Description
The banking system in India is significantly different from that of other Asian nations because of the country's unique geographic, social, and economic characteristics. India has a large population and land size, a diverse culture, and extreme disparities in income, which are marked among its regions.
The Indian Banking Sector
On the Road to Progress
G. H. Deolalkar
G. H. Deolalkar is formerly Managing Director of State Bank of India.
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tries, exports, and banking activities in the developed
commercial centers (i.e., metro, urban, and a limited
number of semi-urban centers).
The banking system’s international isolation was
also due to strict branch licensing controls on foreign
banks already operating in the country as well as
entry restrictions facing new foreign banks. A criterion of reciprocity is required for any Indian bank to
open an office abroad.
These features have left the Indian banking sector with weaknesses and strengths. A big challenge
facing Indian banks is how, under the current ownership structure, to attain operational efficiency suitable for modern financial intermediation. On the other
hand, it has been relatively easy for the public sector
banks to recapitalize, given the increases in
nonperforming assets (NPAs), as their Governmentdominated ownership structure has reduced the conflicts of interest that private banks would face.
Financial Structure
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The banking system in India is significantly different
from that of other Asian nations because of the
country’s unique geographic, social, and economic
characteristics. India has a large population and land
size, a diverse culture, and extreme disparities in income, which are marked among its regions. There are
high levels of illiteracy among a large percentage of
its population but, at the same time, the country has a
large reservoir of managerial and technologically advanced talents. Between about 30 and 35 percent of
the population resides in metro and urban cities and the
rest is spread in several semi-urban and rural centers.
The country’s economic policy framework combines
socialistic and capitalistic features with a heavy bias
towards public sector investment. India has followed
the path of growth-led exports rather than the “exportled growth” of other Asian economies, with emphasis
on self-reliance through import substitution.
These features are reflected in the structure, size,
and diversity of the country’s banking and financial
sector. The banking system has had to serve the goals
of economic policies enunciated in successive fiveyear development plans, particularly concerning equitable income distribution, balanced regional economic growth, and the reduction and elimination of
private sector monopolies in trade and industry. In
order for the banking industry to serve as an instrument of state policy, it was subjected to various nationalization schemes in different phases (1955, 1969,
and 1980). As a result, banking remained internationally isolated (few Indian banks had presence
abroad in international financial centers) because of
preoccupations with domestic priorities, especially
massive branch expansion and attracting more people
to the system. Moreover, the sector has been assigned the role of providing support to other economic sectors such as agriculture, small-scale indus-
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The Banking Sector
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Overview of Banking and
Financial Institutions
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A STUDY OF FINANCIAL MARKETS
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The Indian financial system comprises the following
institutions:
1. Commercial banks
a. Public sector
b. Private sector
c. Foreign banks
d. Cooperative institutions
(i) Urban cooperative banks
(ii) State cooperative banks
(iii) Central cooperative banks
2. Financial institutions
a. All-India financial institutions (AIFIs)
b. State financial corporations (SFCs)
c. State industrial development corporations
(SIDCs)
3. Nonbanking financial companies (NBFCs)
4. Capital market intermediaries
About 92 percent of the country’s banking segment
is under State control while the balance comprises
private sector and foreign banks. The public sector
commercial banks are divided into three categories.
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52.52
7.68
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0.14
0.36
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0.52
4.74
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State bank group (eight banks): This consists of
the State Bank of India (SBI) and Associate Banks
of SBI. The Reserve Bank of India (RBI) owns the
majority share of SBI and some Associate Banks of
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SBI. SBI has 13 head offices governed each by a
board of directors under the supervision of a central
board. The boards of directors and their committees
hold monthly meetings while the executive committee of each central board meets every week.
Nationalized banks (19 banks): In 1969, the Government arranged the nationalization of 14 scheduled commercial banks in order to expand the branch
network, followed by six more in 1980. A merger
reduced the number from 20 to 19. Nationalized banks
are wholly owned by the Government, although some
of them have made public issues. In contrast to the
state bank group, nationalized banks are centrally governed, i.e., by their respective head offices. Thus, there
is only one board for each nationalized bank and meetings are less frequent (generally, once a month).
The state bank group and nationalized banks are
together referred to as the public sector banks
(PSBs). Tables 1 and 2 provide details of public issues and post-issue shareholdings of these PSBs.
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Table 2: Issue of Subordinated Debt Instruments
for Inclusion in Tier-2 Capital During the
Year Ended March 1998 (Rs billion)
Name of Bank
Amount Permitted
Amount Raised
Punjab & Sind Bank
1.0
1.0
Bank of India
7.0
nil
Syndicate Bank
0.8
0.6
Dena Bank
2.0
1.5
Source: Reserve Bank of India.
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GDR = global depository receipt.
a Reserve Bank of India/State Bank of India.
Source: Reserve Bank of India.
Total
State Bank of Travancore
Corporation Bank
Bank of India
Bank of Baroda
Dena Bank
Oriental Bank of Commerce
State Bank of Bikaner & Jaipur
State Bank of India (GDR)
State Bank of India
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January 1998
October 1997
February 1997
December 1996
October 1994
December 1996
November 1997
October 1996
December 1993
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Equity Before
Public Issue
Date of Issue
Name of Bank
Table 1:
Public Equities by Public Sector Banks, 1993–1998 (Rs billion)
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2.74
2.00
Equity
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0.75
0.15
0.35
2.66
0.38
0.82
5.25
1.50
4.89
7.50
1.00
1.96
3.00
1.20
0.65
0.60
1.28
1.47
0.60
12.18
19.38
Premium
Public Issue
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60.15
0.90
3.04
6.75
8.50
3.60
1.80
0.73
12.70
22.12
Total
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0.38
0.82
4.89
1.96
1.28
1.47
0.38
3.14
3.14
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0.12
0.38
1.50
1.00
0.65
0.60
0.13
2.12
1.60
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0.50
1.20
6.39
2.96
1.93
2.07
0.50
5.26
4.74
Total
Others
Governmenta
Equity After Public Issue
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76.00
68.33
77.00
66.88
66.48
71.00
75.00
59.73
66.34
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31.67
24.00
23.00
33.12
33.52
29.00
25.00
41.27
33.66
Others
Governmenta
Percent Share
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THE INDIAN BANKING SECTOR: ON THE ROAD TO PROGRESS
Regional Rural Banks (RRBs): In 1975, the
state bank group and nationalized banks were required to sponsor and set up RRBs in partnership
with individual states to provide low-cost financing
and credit facilities to the rural masses.
Table 3 presents the relative scale of these public
sector commercial banks in terms of total assets.
The table clearly shows the importance of PSBs.
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Total Assets
(Rs billion)
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Number
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2,043.56
3,519.05
444.54
161.13
559.11
190.51a
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19
25
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39
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RBI is the banker to banks—whether commercial,
cooperative, or rural. The relationship is established
once the name of a bank is included in the Second
Schedule to the Reserve Bank of India Act, 1934.
Such bank, called a scheduled bank, is entitled to
facilities of refinance from RBI, subject to fulfillment
of the following conditions laid down in Section 42
(6) of the Act, as follows:
• it must have paid-up capital and reserves of an
aggregate value of not less than an amount specified from time to time; and
• it must satisfy RBI that its affairs are not being
conducted in a manner detrimental to the interests of its depositors.
The classification of commercial banks into scheduled and nonscheduled categories that was introduced
at the time of establishment of RBI in 1935 has been
extended during the last two or three decades to include state cooperative banks, primary urban coop-
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Reserve Bank of India and Banking
and Financial Institutions
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More than 40,000 NBFCs exist, 10,000 of which
had deposits totaling Rs1,539 billion as of March 1996.
After public frauds and failure of some NBFCs,
RBI’s supervisory power over these high-growth and
high-risk companies was vastly strengthened in January 1997. RBI has imposed compulsory registration
and maintenance of a specified percentage of liquid
reserves on all NBFCs.
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Source: Reserve Bank of India.
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aAs of March 1996.
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State Bank of India and associates
Nationalized banks
Old private sector banks
New private sector banks
Foreign banks
Regional rural banks
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Bank
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Table 3: Structure of the Banking Industry in
Terms of Total Assets, March 1997
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A STUDY OF FINANCIAL MARKETS
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erative banks, and RRBs. RBI is authorized to exclude the name of any bank from the Second Schedule if the bank, having been given suitable opportunity to increase the value of paid-up capital and improve deficiencies, goes into liquidation or ceases to
carry on banking activities.
A system of local area banks announced by the
Government in power until 1997 has not yet taken
root. RBI has given in principle clearance to five
applicants.
Specialized development financial institutions
(DFIs) were established to resolve market failures
in developing economies and shortage of long-term
investments. The first DFI to be established was the
Industrial Finance Corporation of India (IFCI) in 1948,
and was followed by SFCs at state level set up under a special statute. In 1955, Industrial Credit and
Investment Corporation of India (ICICI) was set up
in the private sector with foreign equity participation. This was followed in 1964 by Industrial Development Bank of India (IDBI) set up as a subsidiary
of RBI. The same year saw the founding of the first
mutual fund in the country, the Unit Trust of India
(UTI).
A wide variety of financial institutions (FIs) has
been established. Examples include the National
Bank for Agriculture and Rural Development
(NABARD), Export Import Bank of India (Exim
Bank), National Housing Bank (NHB), and Small
Industries Development Bank of India (SIDBI),
which serve as apex banks in their specified areas
of responsibility and concern. The three institutions
that dominate the term-lending market in providing
financial assistance to the corporate sector are
IDBI, IFCI, and ICICI. The Government owns insurance companies, including Life Insurance Corporation of India (LIC) and General Insurance Corporation (GIC). Subsidiaries of GIC also provide
substantial equity and loan assistance to the industrial sector, while UTI, though a mutual fund, conducts similar operations. RBI also set up in April
1988 the Discount and Finance House of India Ltd.
The magnitude and complexity of the Indian banking
sector can be understood better by looking at some
basic banking data. Table 4 shows classification of
banks based on working funds.
Table 4: Classification of Banks Based on Working
Funds, as of 31 March 1997
Classification
Working Funds (Rs billion)
Small
Up to 50
Medium
50–100
Large
100–250
Very Large
250–500
Exceptionally Large
Above 500
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Magnitude and Complexity
of the Banking Sector
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Source: Reserve Bank of India.
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(DFHI) in partnership with SBI and other banks to
deal with money market instruments and to provide
liquidity to money markets by creating a secondary
market for each instrument. Major shares of DFHI
are held by SBI.
Liberalization of economic policy since 1991 has
highlighted the urgent need to improve infrastructure in order to provide services of international standards. Infrastructure is woefully inadequate for the
efficient handling of the foreign trade sector, power
generation, communication, etc. For meeting specialized financing needs, the Infrastructure Development Finance Company Ltd. (IDFC) was set up
in 1997. To nurture growth of private capital flows,
IDFC will seek to unbundle and mitigate the risks
that investors face in infrastructure and to create
an efficient financial structure at institutional and
project levels. IDFC will work on commercial orientation, innovations in financial products, rationalizing the legal and regular framework, creation of a
long-term debt market, and best global practices on
governance and risk management in infrastructure
projects.
NBFCs undertake a wide spectrum of activities
ranging from hire purchase and leasing to pure investments. More than 10,000 reporting NBFCs (out
of more than 40,000 NBFCs operating) had deposits of Rs1,539 billion in 1995/96. RBI initially limited
their powers, aiming to moderate deposit mobilization in order to provide depositors with indirect protection. It regulated the NBFCs under the provisions of Chapter IIIB of the RBI Act of 1963, which
were confined solely to deposit acceptance activities of NBFCs and did not cover their functional
diversity and expanding intermediation. This rendered the regulatory framework inadequate to control NBFCs. The RBI Working Group on Financial
Companies recommended vesting RBI with more
powers for more effective regulation of NBFCs. A
system of registration was introduced in April 1993
for NBFCs with net owned funds (NOF) of
Rs5 million or above.
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THE INDIAN BANKING SECTOR: ON THE ROAD TO PROGRESS
In terms of growth, the number of commercial
bank branches rose eightfold from 8,262 in June 1969
(at the time of nationalization of 14 banks) to 64,239
in June 1998. The average population per bank
branch dropped from 64,000 in June 1969 to 15,000
in June 1997, although in many of the rural centers
(such as in hill districts of the North), this ratio was
only 6,000 people per branch. This was achieved
through the establishment of 46,675 branches in rural and semi-urban areas, accounting for 73.5 percent of the network of branches. As of March 1998,
deposits of the banking system stood at Rs6,013.48
billion and net bank credit at Rs3,218.13 billion.
The number of deposit accounts stood at 380 million and the number of borrowing accounts at 58.10
million. Tables 5, 6, and 7 reflect the diversification
of branch network attained by commercial banks,
the regional balance observed since nationalization,
and stagnation in branch expansion in the post-reform period. There has been a net decline in the number of rural branches and a marginal rise in the number of semi-urban branches.
The outreach of cooperative banks and RSBs is
shown in Table 8.
In an effort to increase the flow of funds through
cooperative banks, the resources of the main
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46.8
33.0
44.2
25.0
0.0
37.5
85.7
51.7
State Bank of India
Associate Banks of SBI
Nationalized banks
Indian private sector banks
Foreign banks in India
Nonscheduled banks
Regional rural banks
Total
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Sources: Indian Bank’s Association, Reserve Bank of India.
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4,127
1,387
13,897
1,136
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3
12,368
32,918
State Bank of India
Associate Banks of SBI
Nationalized banks
Indian private sector banks
Foreign banks in India
Nonscheduled banks
Regional rural banks
Total
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Number of branches
2,412
1,346
936
1,490
718
605
6,518
5,971
5,083
1,567
1,049
783
3
17
161
2
1
2
1,791
277
3
13,783
9,379
7,573
Percent distribution
27.3
15.3
10.6
35.5
17.1
14.4
20.6
19.0
16.2
34.6
23.1
17.3
1.7
9.4
88.9
25.0
12.5
25.0
12.4
1.9
0.0
21.7
14.7
11.9
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100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
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46.6
32.6
43.7
24.3
0.0
33.3
85.4
51.2
4,120
1,389
13,914
1,145
0
3
12,311
32,882
8,821
4,200
31,469
4,535
181
8
14,439
63,653
Total
Metropolitan
Urban
As of 30 June 1997
Semi-urban
Rural
Bank Group
Bank Group and Population Groupwise Distribution of Commercial Bank Branches in India
Rural
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Metropolitan
Urban
Number of branches
2,414
1,358
947
1,505
744
623
6,616
6,100
5,176
1,609
1,102
860
3
17
168
2
1
3
1,822
282
5
13,971
9,604
7,782
Percent distribution
27.3
15.4
10.7
35.3
17.5
14.6
20.8
19.2
16.3
34.1
23.4
18.2
1.6
9.0
89.4
22.3
11.1
33.3
12.6
2.0
0.0
21.7
15.0
12.1
Semi-urban
As of 30 June 1998
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100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
8,839
4,261
31,806
4,716
188
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14,420
64,239
Total
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A STUDY OF FINANCIAL MARKETS
Table 5:
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refinancing agency, NABARD, were boosted substantially through deposits under the Rural Infrastructure Development Fund placed by commercial banks,
as well as through the improvement of NABARD’s
capital base and increase in the general line of credit
by RBI. The functioning of cooperative banking institutions did not show much improvement during
1996/97 and 1997/98. With deposits and credit indicating general deceleration, the overdue position of
these institutions remained more or less stagnant.
However, cooperative banks emulated the changing
structure and practices of the commercial banking
sector in revamping their internal systems, ensuring
in the process timely completion of audit and upgrading of their financial architecture. In various regions,
there is a differing pattern of cooperative banking,
determined according to the strength of the cooperative movement. Some cooperatives such as those
in the dairy and sugar sectors are as big as corporate
entities. In fact, dairy cooperatives compete with multinational corporations such as Nestlé.
There is also a category in the cooperative sector
called primary (urban) cooperative banks (PCBs).
As of March 1998, there are 1,416 reporting PCBs
catering primarily to the needs of lower- and middleincome groups. These are mainly commercial in character and located mostly in urban areas. Some have
become a competitive force with notably big branch
network and high growths recorded. As of 1998,
PCBs have deposits of Rs384.72 billion and advances
of Rs264.55 billion, as indicated in Table 9. Table 10
shows the gross NPA ratio of PCBs.
The advances of PCBs fall in the majority of categories of priority sectors prescribed for PSBs and
their recovery performance is better than that of
PSBs.
The cooperative banks also perform basic functions of banking but differ from commercial banks in
the following respects:
• commercial banks are joint-stock companies under the Companies Act of 1956, or public sector
banks under a separate Act of the Parliament.
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THE INDIAN BANKING SECTOR: ON THE ROAD TO PROGRESS
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Table 6: Credit-Deposit Ratio and Investment-and-Credit-Deposit Ratio of Scheduled Commercial Banks,
By Region (percent)
Investment-and-Credit-Deposit Ratio
1996
Northern Region
48.6
60.8
1997
1998
1995
1996
51.0
54.5
53.4
66.5
35.6
34.5
Eastern Region
47.1
47.7
29.9
58.5
68.8
56.9
39.8
63.2
62.7
63.4
40.5
63.2
69.4
Southern Region
69.4
76.6
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39.0
Western Region
35.1
55.1
57.3
55.7
65.5
68.0
67.2
73.9
72.3
80.5
80.9
87.1
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Central Region
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Northeastern Region
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1995
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Credit-Deposit Ratio
Region
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Sources: Indian Bank’s Association, Reserve Bank of India.
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Table 7: Distribution of Commercial Bank Branches, By Regiona
Average Population per Bank Branch (thousand)
1997
1,253
10,003
90
1,898
1998
1969
1997
1998
10,159
46
12
12
1,898
203
19
20
878
11,506
Central Region
1,090
13,143
11,567
135
18
18
13,225
115
18
18
9,951
38
14
14
17,430
44
13
13
9,828
2,996
17,267
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1,955
Southern Region
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Western Region
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Eastern Region
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Northeastern Region
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Northern Region
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1969
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Number of Branches
Region
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a Data are as of June 30 of each year.
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Sources: Indian Bank’s Association, Reserve Bank of India.
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Table 8: Outreach of Cooperative Banks and Regional Rural Banks, as of March 1997
SCBs
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Number of Branches
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Number of Banks
Deposits (Rs billion)
Loans and Advances (Rs billion)
1,764.92
289.46
288.12
299.57
167.64
85.00
11,791
196
14,513
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364
RRBs
19
854
PCARDBs
738
745
1.63
21.51
. 0.59
14.52
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SCARDBs
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DCCBs
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779
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Name
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Table 10:
Gross Nonperforming Asset Ratio of
Primary (Urban) Cooperative Banks
1996
1997
1998
Perioda
Number of
Reporting PCBs
NPA/Total
Advances (%)
38.48
46.95
56.59
241.65
307.14
384.72
7.58
6.19
8.39
179.08
215.50
264.55
1,327
1,363
1,416
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Number of reporting banks
1995
1996
1997
1998
832
1,161
1,363
179
13.9
12.9
13.3
11.0
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Loans outstanding
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Borrowings
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Deposits
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Owned funds
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Item
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Table 9: Primary (Urban) Cooperative Bank
Deposits and Other Funds (Rs billion)
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DCCB = district credit cooperative bank, PCARDB = primary cooperative agriculture and rural development bank, RRB = regional rural bank, SCB = scheduled commercial
bank, SCARDB = state cooperative and agricultural rural development bank.
Sources: Reserve Bank of India, National Bank for Agriculture and Rural Development.
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Source: Reserve Bank of India.
NPA = nonperforming asset, PCB = primary (urban) cooperative bank.
a As of 31 March.
Source: Reserve Bank of India.
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Cooperative banks were established under the
Cooperative Societies Acts of different states;
• cooperative banks have a three-tier setup, with
state cooperative bank at the apex, central/district cooperative banks at district level, and primary cooperative societies at rural level;
• only some of the sections of the Banking Regulation Act of 1949 (fully applicable to commercial banks), are applicable to cooperative banks,
resulting in only partial control by RBI of cooperative banks; and
• cooperative banks function on the principle of
cooperation and not entirely on commercial parameters.
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A STUDY OF FINANCIAL MARKETS
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The Nonperforming Asset Problem
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Policy Issues in the
Banking Sector
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OPTIMISM WITH RESPECT TO THE
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Nonperforming Asset Level and Ratios
of Public Sector Banks
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392.53
410.41
383.85
416.61
435.77
456.53
NPA/
Total Assets
(percent)
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1993
1994
1995
1996
1997
1998
NPA/Gross
Advances
(percent)
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11.8
10.8
8.7
8.2
7.8
7.0
NPA = nonperforming assets.
Source: Reserve Bank of India.
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23.2
24.8
19.5
18.0
17.8
16.0
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Year
Gross NPAs
(Rs billion)
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Table 11:
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The NPAs of public sector banks were recorded at
about Rs457 billion in 1998 (Table 11). By 1997/98
banks had managed to recover Rs250 billion and provisioned for Rs181.39 billion. But since new sets of
loans go bad every year, the absolute figures could
be increasing. About 70 percent of gross NPAs are
locked up in “hard-core” doubtful, and loss assets,
accumulated over years. Most of these are backed
by securities, and, therefore, recoverable. But these
are pending either in courts or with the Board for
Industrial and Financial Reconstruction (BIFR).
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?
NONPERFORMING ASSET PROBLEM
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66
NPAs in Indian banks as a percentage of total
assets is quite low. The NPA problem of banking
institutions in India is exaggerated by deriving NPA
figures based on percentage against risk assets instead of total earning assets. The Indian banking system also makes full provisions and not net of
collaterals as practiced in other countries.
Narasimham Committee (II) noted the danger of
opaque balance sheets and inefficient auditing systems resulting in an underrating of NPAs. Nevertheless, there is a general feeling that the NPA problem
is manageable. Considerable attention is being devoted to this problem by RBI, individual banks, and
shareholders (Government and private).
With the increasing focus internationally on NPAs
during the 1990s affecting the risk-taking behavior of
banks, governments and central banks have typically
reacted to the problem differently depending on the
politico-economic system under which the banks operate. In some countries such as Japan, banks have
been encouraged to write off bad loans with retained
earnings or new capital or both. This ensures that the
cost of resolving the NPA problem is borne by the
banks themselves. However, this policy is not suitable
for countries such as India where the banks neither
have adequate reserves nor the ability to raise new
capital. In some countries, the banks are State owned
so the final responsibility of resolving the problem lies
with the respective national government. In these cases,
the governments concerned have been forced to
securitize the debt through debt underwriting and recapitalization of the banks. For instance, in Hungary,
guarantees were established for all or part of the bad
loans with the banking system, while in Poland, loans
have been consolidated with the help of long-term restructuring bonds.
Most of these countries have emphasized efforts
to recover the bad loans from the borrowers, usually
in conjunction with one or both the measures mentioned above. If direct sale of the assets of defaulting
firms was deemed nonviable, banks were encouraged
to coerce these firms to restructure. The former
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THE INDIAN BANKING SECTOR: ON THE ROAD TO PROGRESS
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Outstanding Advances to Priority Sectors by Public Sector Banks
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Table 12:
Agriculture
Small-scale industries
Others a
Total
162.00
257.00
22.00
441.00
212.04
215.61
104.32
531.97
Agriculture
Small-scale industries
Others a
Total
5.4
8.5
0.7
14.6
15.0
15.3
7.4
37.8
March
1995
March
1996
March
1997
March
1998
Amount (Rs billion)
235.13
263.51
258.43
294.82
124.38
137.51
617.94
696.09
310.12
315.42
165.48
791.31
343.05
381.09
188.81
913.19
16.4
16.6
8.7
41.7
15.7
17.5
8.7
41.8
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March
1994
Percent of Net Bank Credit
13.9
14.3
15.3
16.0
7.4
7.5
36.6
37.8
a Include small transport operations, self-employed persons, rural artisans, etc.
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June
1969
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MAIN CAUSES OF NONPERFORMING ASSETS
One of the main causes of NPAs in the banking sector is the directed loans system under which commercial banks are required to supply a prescribed
percentage of their credit (40 percent) to priority
sectors. Table 12 shows that credit supply of PSBs
to the priority sectors has increased gradually to a
little more than 40 percent of total advances as of
March 1998. Loans to weaker sections of society
under state subsidy schemes have led borrowers to
expect that like a nonrefundable state subsidy, bank
loans need not be repaid.
Directed loans supplied to the “micro sector” are
problematic of recoveries especially when some of
its units become sick or weak. Table 13 shows PSB
loans to sick/weak industrial units. Nearly 7 percent
of PSB’s net advances was directed to these units.
Clearly, these units are one of the most significant
sources of NPAs, rather than bank mismanagement
on the scale that has been seen in Japan and some
Southeast Asian countries. The weakness of the
banking sector revealed by the accumulated NPAs
stems more from the fact that Indian banks have to
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Czechoslovakia and Poland, for example, consolidated
all NPAs into one or more “hospital” banks, which
were then vested with the responsibility to recover
the bad loans. In Poland, this centralization of the recovery process was supplemented by regulations that
authorized the loan recovery agency to force the defaulting industrial units to either restructure or face
liquidation. Other countries such as Bulgaria created
“hospital” banks and legalized swap of debt for equity
that gave banks stakes in the defaulting firms, and
hence provided them with the incentive and the power
to restructure the enterprises.
In India, conversion of loans into equity is an option that should be seriously considered instead of
attempting recovery solely through either or both legal means and an asset reconstruction company
(ARC). Unlike NPAs, the substitute asset of equity
will be an intangible investment ready for sale to potential buyers. The DFIs have a formal conversion
clause for debt to be exchanged for equity that ought
to be exercised not only if it is an NPA but also if the
equity is appreciating. This clause has not been so
far much exercised.
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Source: Reserve Bank of India, Report on Trend and Progress of Banking in India 1997/98, July 1997–June 1998.
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Public Sector Banks’ Loans to Sick/Weak Industrial Units (Rs billion)
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Table 13:
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Non-SSI Sick Units
Non-SSI Weak Units
Total
1997
6.36
29.44
1.42
37.22
4.79
30.32
0.98
36.09
1996
1997
33.66
26.24
28.33
88.23
31.07
25.27
29.60
86.14
1996
1997
1996
1997
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Potentially viable units
Nonviable units
Viability not decided
Total
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1996
?
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SSI Sick Units
Item
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SSI = small-scale industry.
Source: Reserve Bank of India, Report on Trend and Progress of Banking in India 1997/98, November 1997.
5.12 5.57
3.31 2.96
3.61
7.11
12.04 15.64
45.14
41.43
58.99
58.55
33.36
37.89
137.49 137.87
67
SMALL-SCALE INDUSTRIES: DECLINE IN SICK
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Operational restructuring of banks should ensure
that NPAs in the priority sectors are reduced, but
not priority sector lending. This will remain a priority
for the survival of banks. Any decisions about insulating Indian banks from priority sector financing
should not be reached until full-scale research is undertaken, taking into account several sources including records of credit guarantee schemes.
UNITS AND NONPERFORMING ASSETS
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serve social functions of supporting economically
weak sectors with loans at subsidized rates.
The Narasimham Report (II) recommended that
the directed credit component should be reduced from
40 to 10 percent. As the directed credit component
of the priority sectors arises from loan schemes requiring Government approval of beneficiaries, banks’
selection standards with regard to eligible borrowers
are being interfered with. The nexus of subsidies
should be eliminated from bank loan schemes. Targets or prescribed percentages of credit allocation
toward the priority sectors should not be confused
with directed credit.
Government subsidy schemes were intended originally to prompt bankers to lend to weaker sectors.
But as the directed credit component became partly
politicized and bureaucratized, the realization has
grown that priority sector bank credit should operate
with the required degree of risk management.
However, the dangers of the priority credit system
to sound banking should not be exaggerated. The
shackles of “directed lending” have been removed and
replaced by tests of commercial viability. Economic
activities classified under priority sector have undergone a metamorphosis and upgrade since 1969 when
banks were first nationalized and assigned the role of
financing the sector. The expansion of the definition
of the priority sector, upgrade in the value limit to determine small-scale industry (SSI) status, and provision for indirect lending through placement of funds
with NABARD and SIDBI have lightened the performance load of banks. Thus, priority sector financing is no longer a drag on banks. But in the long term,
Indian banks should be freed from subsidized lending.
The scope in India for branch expansion in rural
and semi-urban areas is vast and also necessary.
Increasingly, NBFCs operating at such places are
coming under regulatory pressure and are likely to
abandon their intermediation role. Banks will have to
move in to fill the void and these branches will find
priority sector financing as the main business available especially in rural/semi-urban centers.
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A STUDY OF FINANCIAL MARKETS
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68
In 1996-1997, banks conducted a viability study
across the country of 229,234 SSI units and identified 16,220 units as being potentially viable. In its
report on Currency and Finance, RBI said that the
number of sick units fell from 262,376 in March 1996
to 235,032 in March 1997. Of the viable units, 10,539
units had outstanding credit of Rs32.22 billion under
a nursing program for turnaround or rehabilitation.
The RBI has called for half-yearly reports from banks
to monitor progress in industrial rehabilitation. In addition, it has also issued guidelines to banks on the
need for proper coordination between them and termlending institutions in the formulation and implementation of a rehabilitation program.
The main causes of industrial sickness in non-SSI
units were internal factors such as deficiencies in
project management (44.8 percent of the cases) and
shortcomings in project appraisals (7.2 percent), as
well as external factors such as nonavailability of
raw materials, power shortages, transport and financial bottlenecks, increases in overheads, changes in
Government policy, and demand shortfalls. The report notes that the number of sick/weak units, both
SSIs and non-SSIs, decreased by 27,350 (10.3 percent) from 264,750 in March 1996 to 237,400 at endMarch 1997. However, the amount of outstanding
bank credit in this regard increased by Rs3.88 billion
(3 percent) during 1996/97 to Rs137.87 billion.
The SSI sector accounted for about 99 percent of
the total sick units, but the share in total bank credit
outstanding to such units was only 26.2 percent. The
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INCOME RECOGNITION
RBI guidelines stipulate that interest on all NPAs
should not be charged and considered in the income
account. The guidelines create some complications
in the accounting system. For instance, if a loan has
turned into an NPA shortly before the end of a financial year, the interest payments during the current and previous financial years are considered not
yet earned and the corresponding book entries recognizing interest income should be reversed. The
definition of income recognition has become a critical issue in presenting a clear picture on the profit/
loss account of banks. A review and, if necessary,
change in the guidelines and accounting system should
immediately be undertaken.
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number of non-SSI sick units declined marginally from
2,374 in March 1996 to 2,368 in March 1997. Outstanding bank credit to these units also showed a
decline of 2.4 percent from Rs88.23 billion at endMarch 1996 to Rs86.14 billion in March 1997. The
priority sector to which SSI belongs is not such a
burden on banks. On the contrary, it offers a good
spread of risks and business opportunities for all types
of branches—metro, urban, semi-urban, and rural.
On the other hand, in the case of non-SSI industrial
units, banks are not the only source of institutional
finance, a major part of which comes from AIFIs at
the project formulation stage. There will be a need
to separately study NPAs in which banks and AIFIs
have common exposure.
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THE INDIAN BANKING SECTOR: ON THE ROAD TO PROGRESS
CORPORATE ACCOUNTS—TRANSPARENCY
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One of the important amendments introduced by the
2
Companies (Amendment) Ordinance in 1998 requires that companies comply with accounting standards. As a step towards good corporate governance
and better disclosure and presentation of accounts, it
is a milestone. However, it was introduced and implemented in a halfhearted way. While the auditor was
required to check on compliance with accounting
standards, there was no statutory requirement for
the company to make such compliance. Now the
ordinance says that companies shall comply with
accounting standards as defined.
The requirement covers all companies, public
or private, listed or unlisted. That accounting standards are now compulsory is contradicted by the
requirement that if the accounting standards are
not complied with, the fact of such noncompliance,
and the reasons and the financial effect of such
Banks’ Recapitalization Needs in Asia
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Table 14:
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NPA figures may be high in Indian banks, but certain factors need to be noted before comparing the
country’s system with that of other Asian nations.
For instance, only 48 percent of banking institutions’
assets are in corporate loans. The high level of preemption of bank funds by the Government in the form
of cash reserve requirement (CRR) and statutory
liquidity requirement (SLR) is one of the reasons for
low profitability of banks and poor returns on assets.
However, in times of stress, such as the recent economic crisis, these same assets provide balance sheet
strength. India’s contrast with the crisis-affected
countries is clear from Table 14. Bank recapitalization needs in India are the lowest as a percentage of
gross domestic product (GDP) while their contribution to developmental banking is high. This emphasizes the need for the Government to back the PSBs
even in the weak category.
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COMPARISON WITH ASIAN COUNTRIES
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Recapitalization Needs
($ billion)
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GDP 1997
($ billion)
Recapitalization/GDP
(percent)
Loans/Assets
(percent)
1.7
12.2
14.3
9.5
31.4
42
70
52
69
78
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381
205
442
95
153
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India
Indonesia
Korea
Malaysia
Thailand
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Country
GDP = gross domestic product.
6.5
25.0
63.0
9.0
48.0
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tors’ role in this direction are likely to outweigh costs.
Auditors are also required under the new statement
to add a paragraph in their audit report that highlights
the going concern problem by drawing attention to
the relevant note in the financial statement. They
must qualify their report, however, if the management does not make adequate disclosure in the financial statements.
Clients are unlikely to welcome the going concern
qualification and their apprehension may well be reinforced if it restricts their freedom of action, by forcing covenants in loan agreements to be activated or
by restricting the freedom to pay dividends. Moreover, because of the lack of any form of quantification, qualified reports are likely to be fuzzy and may
differ significantly depending on the interpretation of
each audit firm. Following well-settled international
practice, it should be made mandatory for directors
to confirm that the financial statements have been
prepared on the basis of the going concern assumption. Auditors should then examine appropriate financial and other information and, if they are not
satisfied, comment appropriately in their audit report.
PROBLEM OF THE REAL SECTOR VS.
BANKING SECTOR REFORMS
Changes in M3 and its select components—net bank
credit to Government (NBCG) and net bank credit
to commercial sector (NBCCS)—show that credit
offtake has slowed down and even declined in
1998/99 for NBCCS (see Tables 15 and 16). Government funding from banks has been rising in the
last three years. An increase in new bank credit to
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noncompliance shall be disclosed. It is possible that
a company can get away with noncompliance
merely by making the required disclosures.
The “going concern” is a fundamental accounting
concept that allows financial statements to be prepared on the assumption that the enterprises will continue in operational existence in the foreseeable future. The Institute of Chartered Accounts of India in
1998 issued a Statement on Standard Auditing Practices (SAP 16) that aims to establish auditors’ responsibilities regarding the appropriateness of the
going concern assumption as a basis for preparing
financial statements. It also elaborates the need for
planning and conducting audits, gathering sufficient
evidence, and exercising judgment whether the going concern assumption made by directors is appropriate. The practice was to be followed for accounting periods commencing on or after April 1999. The
conclusion that a financial statement has been prepared for a going concern depends on a few fundamental uncertainties.
Prominent among these is availability of future
funding, which may affect future results as well as
investments needed and changes in capital structure.
In addition, auditors will have to look at cash generated from operations and other cash inflows, capital
funding and Treasury policies, inherent strengths and
resources of the business, and availability of liquidity
at the end of the period. All these extend the scope
of the audit. Even if one accepts that auditors are
capable of providing information about business risks
that is useful to investors and other parties, it is questionable whether the benefits of expanding the audi-
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A STUDY OF FINANCIAL MARKETS
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Annual Changes in M3, 1990/91–1997/98 (Rs billion)
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Table 15:
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NBCG
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1,401.93
1,762.38
2,039.18
2,224.19
2,557.78
2,886.20
3,306.19
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na
1,009.97
675.82
970.19
725.81
978.41
1,235.41
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Variation
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M3
2,658.28
3,668.25
4,344.07
5,314.26
6,040.07
7,018.48
8,253.89
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1990/91
1992/93
1993/94
1994/95
1995/96
1996/97
1997/98
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Year
?
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na = not available.
NBCG = net bank credit to Government, NBCCS = net bank credit to commercial sector.
Source: Reserve Bank of India.
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70
Variation in NBCG
NBCCS
Variation in NBCCS
na
360.45
276.80
185.01
333.59
328.42
419.99
1,717.96
2,201.35
2,337.74
2,927.23
3,446.48
3,763.07
4,321.90
na
483.39
136.39
589.49
519.25
316.59
558.83
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THE INDIAN BANKING SECTOR: ON THE ROAD TO PROGRESS
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Monthly Changes in M3, March–July 1998/99 (Rs billion)
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Table 16:
M3
Variation
NBCG
Variation in NBCG
NBCCS
Variation in NBCCS
March
April
May
June
July
8,253.89
8,376.64
8,460.14
8,554.03
8,616.23
na
122.75
83.50
93.89
62.20
3,306.19
3,360.85
3,497.40
3,601.38
3,666.97
na
64.76
136.55
203.98
65.59
4,321.90
4,316.36
4,298.30
4,286.27
4,329.23
na
(5.54)
(18.06)
(12.03)
42.96
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Month
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three problems are interrelated and suggest the need
for short- and long-term measures.
The basic maladies affecting the financial sector
in India are as follows:
• structural weakness of the real sector and lack
of competitiveness in international markets, and
• underdeveloped credit delivery systems that fail
to respond to fast changing situations.
Strengthening the viability of the real sector has
much relevance to the future strength of the Indian
financial system. The Committee on Capital Account
Convertibility has not dwelt on the impact of expected
inflows of capital in relation to efficiency and absorptive capacity of the real sector on the one hand,
while emphasizing the needed strength of the financial sector on the other.
It is mainly the second malady that has to be overcome by banks and financial institutions. Future reforms will have to focus on how the real and the
banking sectors can strengthen each other.
INDIAN CORPORATE SECTOR
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the commercial sector in 1997/98 is partly due
to liquidation of high cost external commercial borrowings. The real differences are more evident in
1998/99 (Table 16).
There is a close connection between the relatively
small flow of finance to enterprises, the downward
trend in the real sector, and the depressed stock
market. The economy’s downward trend has persisted despite several initiatives taken by the monetary authorities.
There has been a large-scale extension of bank
credit to the Government at the expense of the commercial sectors. This suggests that the principal reason for the poor growth of bank loans is “inadequate”
demand, which can be traced to developments in the
real sector. The troubles faced by the real sector
also seem to originate from a fall in market demand
for goods. In many industries, output expansion has
been nil to modest, often with inventory pileups. Adverse market conditions facing consumer goods industries strongly support the hypothesis concerning
demand failure in the real sector.
A cut in the bank rate by itself will have a limited
impact on the economy for the following reasons. First,
even if producers expect to make profits on their investment and banks are willing to lend, investment
may not materialize because of the difficulty of securing complementary finance from a depressed stock
market. Second, banks may be too wary of lending or,
more likely, may not have developed an efficient credit
delivery system to the major part of the economy. Third,
and most important, the large majority of producers
would take a dim view of future profitability of investment in the context of infrastructural bottlenecks. The
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na = not available, ( ) = negative values are enclosed in parentheses.
NBCG = net bank credit to Government, NBCCS = net bank credit to commercial sector.
Source: Reserve Bank of India.
The private sector’s (gross) investment in plant and
machinery rose from Rs120 billion per year (3 percent of GDP) in 1986-1990 to Rs730 billion per year
(7 percent of GDP) in 1995-1997. A sixfold increase
in investment in such a short span is a structural
change brought about by strong macroeconomic fundamentals and corporate management. There were,
however, deficiencies in the management of structural reforms.
The sequencing of the 1991 reforms seemed inappropriate. Securing quick gains in the form of foreign
institutional investor (FII) inflows into the capital
71
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CORPORATE SECTOR CONTROL OF
NONPERFORMING ASSETS
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market (instead of foreign direct investment [FDI])
failed to improve the real sector and fueled stock
price rises (the Government also did not take advantage of disinvestment in public sector holdings). Capital market liberalization and opening up avenues of
foreign funds raised through global depository receipt
(GDR) issues, and other sources were not matched
by a full upgrade and modernization of the industries
to increase their competitiveness.
A persistent trade deficit is indicative of an incorrect sequencing of reforms (in contrast with the
People’s Republic of China [PRC], which from 1990
onwards boosted foreign reserves through trade surpluses from manufactured goods exports). Not many
Indian listed companies have foreign trading exposure in the form of exports or imports. The concern
for Indian banks and FIs naturally is the risk of
underperformance of the real sector and lack of adequate cushion. Many companies have faced difficulties in coping with adverse foreign exchange fluctuation because of declines in the value of the rupee.
NPAs of banks with respect to corporate sector
lending have been caused by the following:
• mindless diversification;
• neglect of core competencies;
• diversion of new equity raised into nontradable
assets;
• inattention to cost controls;
• lack of coordination between banks and FIs; and
• rapid growth after liberalization of merchant
banks, which hastily vetted projects and initial
public offerings (IPOs) in the rush to beat competition, neglected to develop a debt market,
and gave extraordinary support to raising of
equity issues by the companies.
The depressed stock market has caused companies to turn back to banks for finance. The loss of
investor confidence happened even after several
reforms in the capital markets (some under the
United States Agency for International Development’s [USAID’s] Financial Institutions Reform Expansion [FIRE]) program.
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A STUDY OF FINANCIAL MARKETS
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72
Banks, FIs, and the market by themselves cannot
exercise control over companies. The reaction of investors to falls in bond and stock prices ensures that
any damage is limited once there is a perception that
something is wrong. Bank financing provides a shield
to companies from such short-term market whims if
the bank is satisfied the unit will pull through. In India, the process of disintermediation is of recent origin and DFIs have, in fact, a lot of hold on companies through their equity stakes and loan stakes in
the units financed. Even as the role of the stock market expands, banks and DFIs still have a significant
role as finance providers and some complementarity
of controls (in terms of rigors of financial discipline)
can be evolved to ensure corporate efficiency.
Banks are highly deficient on the stock market
side (a position well established by the dismal record
of mutual funds and merchant banking subsidiaries
floated by most of the public sector banks). Their
portfolios of investments in bonds and equities (which
are 100 percent risk assets) need to be screened
using credit risk assessment standards and not by
market prices alone. Banks also must adopt methods of converting debt into equities in NPA accounts
whenever possible to either ensure turnaround in
corporate performance, or else sell equities to limit
future losses. Currently, they do not have an exit
route. The case for corporate control is presented in
Table 17, which highlights the extent of cost consciousness in the corporate sector.
Despite competition and falling profits, there has
been no significant improvement in cost structure.
Also, the slowdown has not made cost consciousness a top concern. This is exactly what banks and
FIs have to be worried about. Equity holders, banks,
and FIs can position themselves as drivers of shareholder value. Credit risk analysis needs to be complemented by cost structure analysis and output efficiency with reference to the companies’ capital and
stock of borrowed funds. This is one reason why
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Cost Curve—Composition and Structure
(as percent of sales)
1989/90 1993/94 1994/95 1997/98
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16.1
5.2
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17.2
4.5
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15.7
5.2
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14.0
4.9
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49.4
37.4
3.2
1.1
7.7
7.2
5.9
2.5
11.6
1.5
5.8
1.1
1.6
2.9
0.1
3.9
0.3
0.4
0.3
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49.0
37.0
3.1
1.2
7.7
7.1
5.8
2.7
12.9
1.5
5.1
0.9
1.5
2.6
0.1
3.6
0.2
0.2
0.3
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48.5
36.2
3.4
1.2
7.7
7.5
6.1
2.6
12.5
1.6
5.1
0.8
1.6
2.6
0.1
3.6
0.3
0.4
0.2
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49.2
38.3
3.6
0.5
6.9
8.5
5.9
2.3
13.5
1.7
4.6
0.6
1.4
2.5
0.0
3.8
0.5
0.3
0.0
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Raw materials, stores
Raw materials
Stores and spares
Packaging expenses
Purchase of finished goods
Wages and salaries
Energy (power and fuel)
Other manufacturing expenses
Direct taxes
Repair and maintenance
Selling and distribution expenses
Advertising
Marketing
Distribution
Amortization
Miscellaneous expenses
Nonrecurring expenses
Less: Expenses capitalized
Interest capitalized
Profit before depreciation,
interest, and tax
Interest
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Item
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Table 17:
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THE INDIAN BANKING SECTOR: ON THE ROAD TO PROGRESS
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DEBT RECOVERY TRIBUNAL REVAMP
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banks and FIs should maintain credit files on equity
or other tradable instruments of each issuer. In the
US, the Federal Reserve and Federal Deposit Insurance Corporation (FDIC) guidelines emphasize this
type of credit control. While analyzing credit offtake
volumes, RBI equates such portfolio holdings of banks
to loans and advances. Qualitatively, the risk-control
mechanism for the two categories of assets has to
be on absolute par level.
Table 17 also reflects how interest from borrowing from banks and FIs remains high among total
business costs of borrowers, while banks and FIs
have high liquidity. This problem can be combated
by macroeconomic intervention to reduce interest
rates to enable the economy to expand and the banks
to outgrow their problems, and by banks and FIs ensuring efficient use of capital by borrowers to improve allocative efficiency of resources.
The culture of just in time (JIT) inventories and
quick response (QR) to maintain an efficient supply
chain is still not evident in Indian business management. The credit delivery system is anchored around
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Source: National Council for Applied Economic Research.
requirements of average/peak inventory holdings and
outstanding receivables, although the earlier RBI
stipulations of industry-wise norms have been abolished. Banks are now free to decide but buildup of
current assets in borrowing units pushes up interest
costs of borrowing for existing borrowers and results in nonavailability of resources to new borrowers. Surplus liquidity in banks today is not an indicator of efficient allocation of credit resources.
Other issues concerning corporate control emerge
from closer analysis of how cash credits extended
by banks became NPAs of defaulting borrowers while
they floated new industries with the help of DFIs, as
well as how BIFR cases have dragged on. There
are 60 public sector units under BIFR review. Banks
and FIs need to study how favored projects of the
past became sick units later. Lack of transparency
in the accounts of corporates helped them to disguise cash flow projections for sourcing credit from
banks and FIs.
The final report of the working committee on Debt
3
Recovery Tribunals (DRTs) has recommended the
revamp of the tribunals to ensure that they are not
burdened with more than a specified number of cases.
It has also called for the exclusion of cases under
the Sick Industrial Companies Act (SICA) if these
cases are filed with DRTs. In short, this will mean
that DRTs could be given powers to override those
of BIFR, and this is the greatest stumbling block to
the recovery of bad debts.
According to the working group, not only should
there be a tribunal in every state but there should
also be more than one DRT in the same state if it is
justified by the workload of the tribunals. The DRTs’
prosecuting officers should not face more than 30
cases on any given date and there should not be more
than 800 cases in the pipeline at any given point. If
the number of cases exceeds 800, the Government
should consider appointing more tribunals to deal with
4
such cases. While the working committee has
73
ALL-INDIA FINANCIAL INSTITUTIONS
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NONPERFORMING ASSETS OF
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The net NPAs-total loans ratio at IDBI stood at
10.1 percent, ICICI at 7.7 percent, and IFCI at
13.6 percent as of 31 March 1998. However, loans
from other AIFIs such as LIC, GIC, UTI, and their subsidiaries, Risk Capital and Technology Corporation
(RCTC), Technology Development and Information
Company of India (TDICI), and Tourism Finance
Corporation of India (TFCI), to the industrial sector
have been substantial, but the data on their NPAs are
not readily available. For state-level institutions such
as SFCs and SIDCs, which lend to medium-size industry and SSI sectors, the NPA data are also not readily
available. State-level institutions benefit from a special recovery procedure allowed under their separate
enactment. With the exception of IDBI, ICICI, and
IFCI, the other AIFIs are not under RBI’s regulatory
discipline. There is a need to study features of their
loan operations, credit control, and NPAs.
Disclosure, Accounting Framework,
and Supervision
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Government ownership in banks attracts parliamentary review. The Estimates Committee of Parliament
takes a serious view of adverse comments made
against top managements of PSBs and NPAs on
account of transgression of powers. The committee
called for a total revamp of the training system for
bank officers. The committee also noted that public
sector undertaking (PSU) banks have to be able to
contain NPAs at a par with international standards
where the tolerable levels of NPAs are “around 3 to
4 percent.”
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PARLIAMENTARY REVIEW
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PUBLIC SECTOR BANKS’ BAD DEBTS:
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A total of 320 cases were registered with BIFR in
1998. This exceeded the 230 cases registered in
1997 and was a far cry from the 97 cases recorded
in 1996. According to Board officials, a more than
threefold rise in the number of cases registered
since 1996 could be due to the competition that
companies are facing because of economic liberalization.
On the other hand, the board seems to be unable
to cope with the deluge of cases. It is working with
only one bench and eight members. SICA provides
that the board shall consist of a chairman and a
minimum of two and maximum of 14 members.
From January to November 1998, the board disposed only 127 cases compared to 220 cases in
1997. With the disposal of another five to ten cases
in 1998, this adds up to a dismal record of about
135 cases—only almost half of the number of cases
disposed in 1997.
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RECONSTRUCTION
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FOR INDUSTRIAL AND FINANCIAL
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INADEQUACIES OF THE BOARD
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suggested that more recovery officers should be appointed to ensure speedy recovery of bank dues, it
has also stated that recovery officers may be given
the assistance of police and professional debt recovery agencies.
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A STUDY OF FINANCIAL MARKETS
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74
Greater transparency in banks’ balance sheets and
penal action by RBI, including against bank auditors,
require highly focused action. Internal audits in banks,
now supervised by audit committees of respective
boards, have been more a formality than reflecting
management’s reporting responsibility to the stockholders of the banks. High standards of preventive
and detective (internal) controls are required. Risk
management with respect to “off-balance sheet
items” requires considerable attention as evidenced
by instances of losses on letters of credits and guarantees business. This applies also to auditing off-balance sheet items. At the macro level, the size of
NPAs as a percentage of GDP provides a good
measure to assess the soundness of the system.
The issue needs to be tackled in terms of market
segments from which NPAs have emerged: not putting them simply under the umbrella of “priority sector,” or “nonpriority sector” but individually, in much
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restructured troubled loan would not automatically
be classified as an impaired loan. In India, however,
any restructuring automatically classifies the assets
as impaired. Banks and institutions are required to
classify the restructured loans as substandard for two
years and are prohibited from booking interest during this period. The “relaxation” in asset classification norms will mean little in the Indian context.
In developed financial systems, it is beneficial to
have flexibility in determining weights for NPAs.
However, liberal measures should be introduced only
when all local players employ greater transparency
in the asset classification process. It is necessary to
first ensure that companies and borrowers follow
norms of disclosure and transparency. Much needs
to be done in this respect by the Institute of Chartered Accountants of India.
The condition of Indian banks under the present
norms has improved, contributing to a better culture
of recovery. The borrowers must respond with better performance.
SEPARATING SUPERVISION
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RBI is considering changes in asset classification,
income recognition, and provisioning norms in line
with recommendations of the Basle Committee on
Banking Supervision that were made public in October 1998. It remains to be seen if RBI will give banks
and FIs discretion in the classifications of assets,
partially replacing the prevailing rigid norms and redefining provisioning norms taking into account collateral. According to current practice, banks and FIs
are required to make 10 percent provisioning on substandard assets and 20 percent on doubtful assets,
even if the assets are backed by collateral.
The Basle Committee on Banking Supervision circulated a consultative paper entitled “Sound Practices for Loan Accounting, Credit Risk Disclosure,
and Related Matters,” complementing the Basle core
principles in the fields of accounting, and disclosure
for banks’ lending business and related credit risk.
RBI has already taken steps to implement the Basle
core principles, which broadly deal with risk management, prudential regulations relating to capital adequacy,
and various internal control requirements.
Banks and FIs have been insisting that existing
asset classification rules are rigid leaving no scope
for discretion, while the Basle Committee has said
that recognition and measurement of impairment of
a loan cannot be based only on specific rules. The
committee has also indicated that banks should identify and recognize impairment in a loan when the
chances of recovery are dim. It also stated that the
focus of assessment of each loan asset should be
based on the ability of the borrower to repay the
loan. The value of any underlying collateral factors
also plays a major role in this assessment.
Another major difference between the Basle Committee recommendations and the existing asset classification norms in India relates to “restructured”
loans. According to the Basle Committee norms, a
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PRUDENTIAL NORMS
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wider market segments (for example, agriculture as
a market segment has itself many subsegments).
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THE INDIAN BANKING SECTOR: ON THE ROAD TO PROGRESS
The Narasimham Committee (II), while recommending separation of supervision, admits that conflicting
international experience has left no overwhelming
case for either separation or combining of the central bank’s supervisory powers. The likely conflict
between monetary policy and supervisory concerns
justifies the need to combine the two functions. Separate authority structures for the two functions have
more likelihood of coming into conflict with each other.
Economic downturns tend to highlight supervisory
concerns, and can put the banking system at risk and
subject the monetary authority to face the counterpressure of reflecting economic circumstances. The
choice then becomes one of fine balance. Combining
supervisory functions with monetary policy can provide a synergy that will get lost by separation. In fact,
central banks take on the supervisory function in more
than 60 percent of IMF member countries. In the case
of African and Asian countries alone, the figure is
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Regulatory Issues
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reforms were first introduced under recommendation of the Narasimham committee (I), the 27 (then
28) PSBs were placed under A, B, and C categories; i.e., sound banks, banks with potential weakness, and sick banks, respectively. Accordingly, recapitalization and restructuring were carried out for
B and C categories.
For individual ratings by international rating agencies, a bank is assessed as if it were entirely independent and could not rely on external support. The
ratings are designed to assess a bank’s exposure to
risks, appetite for risks, and management of risks.
Any adverse or inferior rating is an indication that it
may run into difficulties such that it would require
support. Such credit rating announcements ignore the
public sensitivity to which the banking system is constantly exposed. The individual and support ratings
are further explained in Table 18.
The public expects banks to try to anticipate
changes, recognize opportunities, deal with and
manage risks to limit losses, and create wealth
through lending. While the best banks may always
play a super-safe role by confining operations to
choice centers and business segments, banks in
India are expected to operate on a high-risk plane.
As such, the Government should support banks
even during stages when they are nudged to offer
equity to the public.
INDIAN BANKS’ ASSOCIATION
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RBI has subjected banks to ratings under capital
adequacy, asset quality, compliance, and system
(CACS); and capital adequacy, asset quality, management, earnings, liquidity, and systems (CAMELS)
models for differentiating supervisory priorities. When
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RATING OF BANKS
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more than 80 percent. In other countries, supervision
involves varying degrees of central bank involvement.
The regulatory and supervisory systems have to
take into account peculiarities of the banking and financial structures as well as historical and cultural
factors. For example, in India, the rural banking sector is large and the cooperative movement strong but
the banks in this sector have remained generally financially weak. No amount of sophisticated monetary policy management is likely to provide props to
this sector. What it needs is financial strengthening,
management upgrades, and different norms of financial supervision with reference to culture and the economic activity of the clients. Rural and semi-urban
populaces need dependable banks and rarely get alternatives in the form of banking competition.
The importance of rural banking sector has been
overlooked in the various deliberations of banking and
financial reforms in India. Several issues need to be
raised in this regard. For instance, the separation of
supervisory functions and monetary policy formulation would only harm the interests of the rural banking
sector, which RBI and NABARD look after. Then,
there is also the question of the large number of urban
cooperative banks, which serve communities in different cities and adjoining areas. How can a separate
supervisory body develop methods and resources to
supervise these banks? Separation of the functions
may not necessarily strengthen either supervision or
monetary policy management, or both.
As NBFCs come increasing under the regulatory
gaze, there will be vacuum in places where there is
no bank and the NBFC is required to fold. Regulators have to ensure that banking expansion is promoted in these places.
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A STUDY OF FINANCIAL MARKETS
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76
The Indian Banks’ Association (IBA) should evolve
into a self-regulatory organization (SRO) that would
work toward strengthening India’s fairly weak banking sector and the sector’s moral regulator. Its broad
agenda should be to encourage the continued implementation of prudential business practices. IBA is
completing an organizational restructuring after which
it will examine its role as an SRO. It is now an advisory organization of banks in India and its members
include most of the PSBs, private banks, and foreign
banks. Its main activities involve generation and ex-
Ratings of Banks
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Table 18:
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THE INDIAN BANKING SECTOR: ON THE ROAD TO PROGRESS
Support Rating
Very Strong. Characteristics may include
outstanding profitability and balance sheet integrity,
franchise, management, operating environment, or
prospects.
A bank for which there is a clear legal guarantee on the part of
the state, or a bank of such importance both internationally and
domestically that support from the state would be forthcoming,
if necessary. The state in question must clearly be prepared
and able to support its principal banks.
Strong. Characteristics may include strong
profitablity and balance sheet integrity, franchise,
management, operating environment or prospects.
A bank for which state support would be forthcoming, even in
the absence of a legal guarantee. This could be, for example,
because of the bank’s importance to the economy or its historic
relationship with the authorities.
Adequate. Possesses one or more troublesome
aspects on profitability and balance sheet integrity,
franchise, and management, operating environment
or prospects.
A bank or bank holding company that has institutional owners of
sufficient reputation and possessing such resources that
support would be forthcoming, if necessary.
Weak. Weaknesses of internal and/or external
origin. There are concerns regarding profitability
and balance sheet integrity, franchise,
management, operating environment or prospects.
A bank for which support is likely but not certain.
Problematic. Has serious problems that either
require or are likely to require external support.
A bank or bank holding company, for which support, although
possible, cannot be relied upon.
IMPROVING REGULATORY FRAMEWORKS TO
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practices. This can, however, be all very well in theory
but difficult to practice because an SRO is more of a
culture than an institution. It takes a long time to breed
a culture of self-regulation. The respect for a supervisor has to be earned and does not happen overnight.
IBA has to transform itself into a “real” industry
body once the IBA management committee acts on
the blueprint for change proposed by a consulting
firm. The proposal is to overhaul the structure of the
organization to increase efficiency. The new focus
is on networking as IBA was, for a long time, working in isolation. Now the objective is to emerge as a
representative body for the banking industry. IBA has
already started interacting with different industries and
looking into various aspects of financing software companies, the film industry, construction companies, and
the shipping industry.
DECREASE SYSTEMIC RISK
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change of ideas on banking issues, policies; and practices; collection and analysis of sectoral data; personnel administration; and wage negotiations between
labor unions and bank managements. But in its new
role, it would reportedly expand its functions to supplement RBI’s role as a legal regulator with a focus on
strengthening the sector.
While the sector’s risk profile improved considerably after prudential norms were introduced in 1994,
by international standards, India’s banking sector is
perceived as fairly weak with poor asset quality by
leading agencies such as Standard & Poor’s. The
SRO would examine and recommend the implementation of more stringent prudential norms as laid out
in the recommendations of the Narasimham Committee (II). It would encourage practices to strengthen the sector. Its expanded role could incorporate
vigilance, improvement in accounting standards and
balance sheet practices, encouraging provisioning, and
tackling the problem of weakness and deteriorating
asset quality in the banking sector.
IBA as an SRO would have to ensure that banks
follow at least a certain minimum level of prudential
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Source: Fitch IBCA.
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Individual Rating
Deregulation has helped promote competition and
efficiency in the banking system in India and will
77
Asset Liability Management
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partite Group agreed that the term “financial conglomerate” would be used to refer to “any group of
companies under common control whose exclusive
or predominant activities consist of providing significant services in at least two different financial sectors (banking, securities, insurance).” Many of the
problems encountered in the supervision of financial
conglomerates would also arise in the case of mixed
conglomerates offering not only financial services,
but also nonfinancial services and products. Coordination between RBI, Insurance Regulatory Authority, and Securities and Exchange Board of India
(SEBI) is becoming increasingly urgent.
MATURITY MISMATCH
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In 1993, the Bank for International Settlements (BIS)
set up a Tripartite Group of banking, securities, and
insurance regulators to consider ways of improving
the supervision of financial conglomerates. The Tri-
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REGULATION OF FINANCIAL CONGLOMERATES
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have a positive impact on systemic risk in the long
run. Initially, however, deregulation has affected the
stability of the banking sector. Substantial progress
has been made toward stronger regulatory frameworks. Changes in banks’ reporting requirements,
improvement in the quality of on-site supervision, and
the establishment of credit information and loan-grading and provisioning requirements have all helped.
More important, a focus on evaluating bank solvency,
more than enforcing a set of detailed regulations, has
resulted in lower systemic risk across the board. But
there are still many instances in which neither investors nor bank supervisors are able to properly monitor an institution’s creditworthiness.
Asset quality is still the main source of risk for a
financial institution and must be carefully assessed.
There are loan classification systems in which bad
loans can be converted into good ones through restructuring and are never reported as bad by rolling
over the debt (“evergreening”). In some instances
the main factor for loan classification is performance
of payment instead of the financial position of borrower, which also creates difficulties in assessing
credit risk. Previously, DFIs in India supported new
industries through equity and loan participation, and
they usually insisted on payment of dues on existing
loans. But these payments may be diverted from
working capital sourced from cash credit facilities
from banks for their existing ventures. In this way,
defaulters could promote new industries. What is
important, therefore, is not merely payment record
but actual surplus generation by the borrowers to
qualify for investment in new ventures. Consolidated
supervision of banks and their subsidiaries is another
important area that needs to be addressed in future
regulatory framework improvements.
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A STUDY OF FINANCIAL MARKETS
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78
Interest rates have changed several times over the
past seven years causing maturity transformations
in assets and liabilities and their frequent repricing.
A clear and continuous statement of rate sensitive
assets and rate sensitive liabilities has to form the
basis of interest rate risk management. RBI is expected to issue guidelines that show that management-driven asset liability management (ALM) initiatives in banks are absent. This is also the reason
why India’s money market has remained mostly as a
call money market that is meant for clearing day to
day temporary surpluses and deficits among banks.
Traditionally, many banks, including the foreign banks,
have used “call” money as a regular funding source.
PSBs are notably absent players in the market for
term funds since they lack data on maturity gaps and
interest rate gaps to be complied under ALM discipline. The common complaints about difficulties in
collection of data from hundreds of rural and semiurban branches will not be combated unless there is
computerization in these branches to facilitate data
compilation progressively.
According to RBI and many PSBs, about 80 percent of deposits are term deposits (one to three
years). Long-term lending (three to five years) comprises about 30 percent of total loans and thus, matu-
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The importance of more sophisticated ALM has increased for Indian banks in view of liberalization of
interest rates and business activities, limits to the
expansion of lending volume, introduction of derivatives, prevailing international discussions concerning
risk management, innovation of computer technology, and globalization. In ALM, risks in the banking
account (which comprises the traditional banking
products including deposits and loans and the trading
account, which mainly comprises short-term trading
products such as foreign exchange and investments)
are managed separately. The primary focus is on
how to hedge the passively arising interest rate risk
in the banking account.
However, given the changes in the business environment, Indian banks and financial institutions have
to move forward to maximize profits through comprehensive measurement and management of market risks, particularly interest rate risk, by
• upgrading the risk management measures for
banking and trading accounts, thus integrating the
risk measurement for the institution as a whole;
• shifting the focus of ALM in the banking account from simply hedging risks to actively taking and controlling risks; and
• reviewing organizational structure to make risk
management more sophisticated and provide for
more flexible ALM operations.
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SOPHISTICATION
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ASSET LIABILITY MANAGEMENT
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rity mismatch is not a serious issue. However, this
claim may not be valid as maturity of deposits and
term loans are not disclosed. Moreover, banks have
invested a large portion of funds in Government securities and debentures (long-term assets). RBI
should highlight and address the real maturity mismatch issue. Call money market is an age-old terminology that RBI itself has to stop referring to in its
publication. The “call” segment of the market is different from the “term” segment in all sophisticated
market centers in the world.
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THE INDIAN BANKING SECTOR: ON THE ROAD TO PROGRESS
An example of such organizational structure review is strengthening the authority of a financial
institution’s ALM committee, or by establishing an
ALM expert section or a middle office. Risk management can shift from the worst method of controlling the market risks related to assets and liabilities to an integrated risk management measure incorporating the credit risks in the banking and trading accounts. This shift would enable objective assessments of profitability and, based on these assessments, a strategic allocation of resources could
be carried out.
In general, the development of ALM operations
has to be in the direction of an objective and comprehensive measurement of various risks, a pursuit
of returns commensurate with the size of the risk,
and a strategic allocation of capital and human resources based on the risk. This can be said to be the
key to successful ALM in an era of financial liberalization. Unless Indian banks and FIs adopt these principles, there can be little progress in the following
critical ALM operations:
• upgrading of trading techniques;
• implementation of flexible ALM operations in the
banking account, such as strategic risk-taking operations that use interest rate swaps and investment securities and strategic pricing of mediumto long-term deposits, as well as the concentration of interest rate risk at the head office through
a review of the interoffice rate; and
• with regard to customer business, the provision
of various financial services based on improved
market risk management ability—for example,
the development of new types of deposit and
loan products involving the use of derivatives and
the provision of ALM services—and the search
for new clients among small- and medium-size
firms through sophisticated credit risk management techniques.
The evolution in financial management in terms
of sophistication in ALM operations has to be an
autonomous response and not driven by regulators.
79
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Banks are required to comply with the SLR by investing in approved securities, e.g., central Government bonds, Treasury bills (T-bills), and state government bonds. Moreover, banks invest in PSU
bonds, corporate debentures, and equities (limit is
5 percent of the increase in the previous year’s deposits). Investments are assessed at market prices.
As for approved securities, only 60 percent of outstanding are assessed at mark-to-market. It is difficult to identify the actual asset position of banks if
approved securities are not assessed at market price.
For this reason, RBI is planning to require banks to
assess 100 percent of the approved securities at markto-market in a few years.
These regulations are based on the Government’s
objective of bringing down fiscal deficit. It recognizes the fact that it is simply not feasible for banks
and FIs to increase the share of Government securities in their portfolio without affecting their own viability and indeed the viability of the productive sectors of the economy.
Despite the progressive reduction in the SLR over
the past five years in the wake of implementation of
Narasimham Committee (I) recommendations, banks
voluntarily directed high deposits growth into riskfree assets of Government securities. This trend coincided with companies raising external commercial
borrowings and issuing GDRs in international markets in preference to borrowings from banks. Backtracking during previous changes in government on
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RISK ASSESSMENT OF INVESTMENT
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Single customer limits are set at less than 25 percent
of net worth of the bank for a single customer, and
less than 50 percent of net worth of the bank for a
group. By definition, a loan includes debentures issued by the customer. As loans of PSBs are limited,
they would be able to comply with these ceilings.
However, small private banks may exceed these
ceilings if proper supervisory measures are not undertaken.
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SINGLE CUSTOMER LIMIT
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A STUDY OF FINANCIAL MARKETS
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80
efforts to curb the fiscal deficit caused monetary
policy to be tight and interest rates to remain high.
Now that an industrial slowdown has set in, RBI has
concluded that nothing should be done to dampen
the emerging signs of incipient recovery and focus
should be largely on strengthening balance sheets of
banks and financial institutions.
Excess investments made by banks in Government securities point to the fact that investable surpluses have not been adequately deployed to finance
industry and trade. Clearly, banks have been unable to predict interest rate changes, the root cause
being that ALM has been neglected. Through
1993/94 to 1997/98, PSBs invested in Government
securities in excess of SLR requirements by an average of 6 to 7 percent. The trend continued even
through periods of high growth in the economy when
the overall GDP grew at more than 7 percent. The
growth in SLR securities with the banks in excess
of the requirement has been high. PSBs had
excess Government securities to the tune of
Rs160.68 billion in March 1994. This grew to
Rs227.15 billion by March 1995, Rs316.77 billion
by March 1997, and Rs408.74 billion by March 1998.
Investments in Government securities are totally
risk free over a certain period. Banks can end up
making large provisions if interest rates rise consistently over several years. This would depreciate the
heavy portfolio acquired, as was demonstrated in 1995
and 1996 when Government securities depreciated
as interest rates perked up. Based on their experience, RBI has begun to assign some risk weight to
Government securities to discourage banks from
buying heavily into them.
Assigning risk weight to Government securities,
however, contradicts the statutory requirement of
maintaining minimum liquidity in Government securities investments. Also, balance sheets would not be
strengthened significantly nor would the attraction
of investing excess funds in Government securities
be removed. Instead, banks should have strong ALM
practices and risk management system in the com-
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ments but the regulatory and risk management apparatus is not fully ready.
DEPOSIT INSURANCE PREMIUMS
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Banks in India need a new attitude toward the scope
and extent of different types of risks. These risks
are made up of the dynamics between many conflicting parameters—for example, balancing the
needs of market constraints, industries, and geographic concentrations with the individual requirements of counterparties and corporate customers.
Information to support such understanding has not
historically been defined nor kept within banks’ systems. Trading portfolios of banks in India are becoming diverse with the range of bonds, equities, and
derivative instruments, and allowance made by RBI
permitting investments in overseas markets. Debt
swaps and interest rate swaps as well as currency
swaps are entered into with foreign banks and such
exposures need special monitoring. There is an eagerness to introduce a variety of derivative instru-
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TRADING RISK MANAGEMENT
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mercial lending area. RBI and Government should
improve bank balance sheets by removing contamination effect of NPAs in the form of Governmentguaranteed loans; i.e., by issuance of special Government bonds in favor of banks for converting such
NPAs into Government debt.
The conflicting considerations—the need to reduce monetary expansion while at the same time
nurturing real growth—starkly illustrate the monetary policy dilemma that RBI faces. It has not proposed to change the CRR or interest rates, and will
continue to manage liquidity through open market
operations and repo operations. RBI will not hesitate to resort to further monetary tightening if inflationary pressures increase or if external developments warrant. Going a step beyond the recommendations of the Narasimham Committee (II) on
introduction of market risk to Government and approved securities, an additional risk weight of
20 percent on investments in Government-guaranteed securities of Government undertaking that do
not form part of a market borrowing program is
also being introduced.
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THE INDIAN BANKING SECTOR: ON THE ROAD TO PROGRESS
The banking crisis that plagued the US during the
1980s was instrumental in drawing the attention of
policy makers to the fact that the system of deposit
insurance has to be reformed. In the absence of
deposit insurance, banks are vulnerable to a run that
will precipitate a liquidity crisis in the financial system. As a consequence, most Governments implicitly or directly guarantee the deposits in their respective banking systems. However, deposit insurance can lead to problems in the form of an increase in the proportion of credit disbursed to risky
borrowers.
This realization led to a reform of the deposit
insurance regime in the US with the enactment of
the Federal Deposit Insurance Corporation Improvement Act, which imparts greater autonomy on the
banks. The Act provides that “as long as it appears
that a bank will be playing with its own money (capital), almost any activity that can be adequately
monitored by the insurer could be permitted. But if
the structured early resolution fails, early resolution
is required through recapitalization by current shareholders, sale, merger or liquidation before the
institution’s capital turns negative.” Clearly, the Act
aims to eliminate agency problems by ensuring that
the losses are restricted to the shareholders, and do
not spill over to affect the depositors or the Government’s budget.
In India, however, the Narasimham Committee
(II) has recommended differentiated premium rates,
which would amount to broadcasting to the public
the status of banks. An alternative would be for the
deposit insurance system to extend rebates to banks
showing improvements and deduct the rebate amount
from the next year’s premium. Rebates would be on
the basis of annual performance whereas penal premium rates would operate only after deterioration is
detected.
81
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Capital adequacy is a self-regulatory discipline and
cannot save banks that are distressed. As such, the
time required for meeting bank capital adequacy must
be shortened to a minimum. The CAMEL rating system clearly recognizes the strength of bank capital
as just one requirement and also an end product of
other processes, mostly management driven. It is
essential to amplify the quality of earnings as it is the
first thing that catches shareholders’ attention. History shows that banking problems germinate during
years of economic boom. When the earnings component becomes volatile and susceptible to sharp
growth that is not sustainable, the quality of loan/risk
assets can become suspect.
PSBs are owned by the Government, therefore,
they have implicit guarantees from the Government,
resulting in the lack of capital adequacy ratio
(CAR) norm. Given the recommendation of the
Narasimham Committee (I) in 1991 on the BIS standard of capital adequacy, a CAR of 8 percent was
to be achieved by March 1996. Twenty-six out of
27 PSBs had complied with this requirement as of
March 1998.
Narasimham Committee (II) recommended CAR
targets of 9 percent by 2000 and 10 percent by 2002.
As many PSBs have already high CARs (some indicated an average CAR of about 9.6 percent as of
March 1998), such targets could be attained. Moreover, as 35 percent of deposits are allocated to CRR
and SLR, coupled with investment in Government
guaranteed bonds, risk assets are not preferred.
However, RBI has introduced a calculation method
that 60 percent of approved securities should be markto-market, and the ratio will be raised to 100 percent
in a few years. Despite the higher mark-to-market
ratio, many banks increased investments in approved
securities to comply with CAR.
The banks will have difficulties raising more capital in the near future, with capital markets sluggish,
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CAPITAL ADEQUACY
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Function of Bank Capital
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A STUDY OF FINANCIAL MARKETS
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82
investor confidence low, and bank issues unpopular
with investors. The need for general provisioning on
standard assets increases the pressure on profitability of banks as Government-guaranteed securities
are prone to default.
RBI has decided to implement certain recommendations of Narasimham Committee (II).
• Banks are to achieve a minimum of 9 percent
CAR by 31 March 2000. Decisions on further
enhancement will be made thereafter.
• An asset will be treated as doubtful if it has remained substandard for 18 months instead of 24
months. Banks may make provisions in two
phases. On 31 March 2001 provisioning will be at
not less than 50 percent on the assets that have
become doubtful on account of the new norms.
• On 31 March 2002, a balance of 50 percent of
the provisions should be made in addition to the
provisions needed by 31 March 2001. A proposal to introduce a norm of 12 months will be
announced later.
• Government-guaranteed advances that have
turned sticky are to be classified as NPAs as
per the existing prudential norms effective 1 April
2000. Provisions on these advances should be
made over a period of four years such that existing/old Government-guaranteed advances that
would become NPAs on account of new asset
classification norms should be fully provided for
during the next four years from the year ending
March 1999 to March 2002 with a minimum of
25 percent each year. To start with, banks should
make a general provision of a minimum of
0.25 percent for the year ending 31 March 2000.
The decision to raise further the provisioning requirement on standard assets shall be announced
in the process.
• Banks and financial institutions should adhere
to the prudential norms on asset classification,
provisioning, etc., and avoid the practice of
evergreening.
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lenges to bank management. The time frame allowed
for adjustments seem to be insufficient since profitability cannot be raised rapidly enough to accommodate additional provisioning and still be considered
attractive by investors. This raises a question on how
far banks will actively support growth through new
financing initiatives. Clearly, additional returns to inject better profitability in the short run have to come
from (already shrunk) avenues of short-term financing and not from new industrial and infrastructure
projects, which entail long gestation periods.
TIER-2 CAPITAL FOR BANKS
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• Banks are advised to take effective steps for
reduction of NPAs and also put in place risk management systems and practices to prevent reemergence of fresh NPAs.
• PSBs shall be encouraged to raise their tier-2
capital, but Government guarantee to bond issues for such purpose is deemed inappropriate.
• Banks are advised to establish a formal ALM
system beginning 1 April 1999. Instructions on
further disclosures such as maturity pattern of
assets and liabilities, foreign currency assets and
liabilities, movements in provision account, and
NPAs, will be issued in due course.
• Arrangements should be put in place for regular
updating of instruction manuals. Compliance has
to be reported to RBI by 30 April 1999.
• Banks are to ensure a loan review mechanism
for large advances soon after their sanction and
continuously monitor the weaknesses developing in the accounts in order to initiate corrective
measures in time.
• A 2.5 percent risk weight is to be assigned to
Government/approved securities by March 2000.
• Risk weights to be assigned for Governmentguaranteed advances sanctioned effective 1 April
1999 are as follows:
– central Government: 0 percent;
– state government: 0 percent;
– governments that remained defaulters as of
31 March 2000: 20 percent; and
– governments that continue to be defaulters after 31 March 2001: 100 percent.
The latest figures (as of 1997/98) for banks’ and
selected financial institutions’ capital adequacy are
shown in Tables 19 and 20. Table 19 indicates that
most PSBs have comfortable CARs but once the
accounts are recast in conformity with the forthcoming provisioning norms, banks will have to start planning for capital issues. The size of bank issues, sequencing, and readiness of the capital market to absorb all public offerings will pose tremendous chal-
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THE INDIAN BANKING SECTOR: ON THE ROAD TO PROGRESS
To meet CAR requirements, seven banks—Canara
Bank, Punjab National Bank, Central Bank of India,
Indian Overseas Bank, United Bank of India, Federal Bank (private sector), and Vijaya Bank—are
finalizing plans to raise about Rs20 billion worth of
subordinated debt, which qualifies as tier-2 capital.
The funds will be raised in the form of bonds from
the domestic private placement markets in 1998/99.
With this, the total amount of tier-2 borrowing (primarily debentures and bonds as against equity shares,
which are considered tier-1 capital) planned in
November 1998 to February 1999 might have exceeded Rs150 billion.
While RBI regulations have capped the coupon
rate on bank offerings to 200 basis points (bp) above
the coupon rate on similar Government securities,
none of these banks can hope to find market interest
at such fine rates. A five- to six-year bank borrowing will have to be capped at about 14 percent as
similar Government borrowing was effected at a
coupon of 11.78-11.98 percent in 1998-1999. However, with the top of the line FIs raising five-year
funds at 14 percent, these banks will have to offer
more incentives to investors. Public issue timing and
pricing is a new challenge for PSBs. There are reports that some banks have invested in tier-2 capital
issues of other banks and it remains to be seen how
it will affect their CAR.
83
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A STUDY OF FINANCIAL MARKETS
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Capital Adequacy Ratio of Public Sector Banks, 1995/96–1997/98 (percent)
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Table 19:
1995/96
1996/97
1997/98
11.60
9.33
9.90
8.80
8.81
9.51
12.38
9.40
9.68
5.07
11.19
8.44
8.49
10.38
2.63
11.30
8.27
neg.
5.95
16.99
3.31
8.23
8.42
7.83
9.50
3.50
neg.
12.17
8.82
10.84
9.31
10.80
11.25
12.14
8.17
11.00
12.05
11.80
10.26
9.07
10.17
9.41
11.30
10.81
neg.
10.07
17.53
9.23
9.15
8.80
3.16
10.53
8.23
11.53
14.58
10.65
10.83
9.83
11.61
13.24
18.14
11.48
11.64
12.37
12.05
9.11
10.90
9.54
10.40
16.90
11.88
1.41
9.34
15.28
11.39
8.81
10.50
9.07
10.86
8.41
10.30
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Name of Bank
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State Bank of India
State Bank of Bikaner & Jaipur
State Bank of Hyderabad
State Bank of Indore
State Bank of Mysore
State Bank of Patiala
State Bank of Saurashtra
State Bank of Travancore
Allahabad Bank
Andhra Bank
Bank of Baroda
Bank of India
Bank of Maharashtra
Canara Bank
Central Bank of India
Corporation Bank
Dena Bank
Indian Bank
Indian Overseas Bank
Oriental Bank of Commerce
Punjab & Sind Bank
Punjab National Bank
Syndicate Bank
United Commercial Bank
Union Bank of India
United Bank of India
Vijaya Bank
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Capital Adequacy Ratioa of Selected
Financial Institutions, 1997 and 1998 (%)
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Table 20:
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neg. = negative.
Source: Reserve Bank of India.
As of 31 March 1997
As of 31 March 1998
IDBI
ICICI
IFCI
SIDBI
IIBI
Exim Bank
NABARD
14.7
13.3
10.0
25.7
10.6
31.5
40.4
13.7
13.0
11.6
30.3
12.8
30.5
52.5
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Global trends in the banking industry in recent years
have focused on cost management, which drove
banks to venture into nontraditional functions, standardize products, centralize activities, and form merg-
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CONSOLIDATION OF THE BANKING INDUSTRY
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Mergers and Recapitalization
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ICICI = Industrial Credit and Investment Corporation of India, IDBI = Industrial
Development Bank of India, IFCI = Industrial Finance Corporation of India, IIBI =
Industrial Investment Bank of India, NABARD = National Bank for Agriculture and
Rural Development, SIDBI = Small Industries Development Bank of India.
a As percent of risk weighted assets.
Source: Reserve Bank of India.
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Institution
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84
ers and alliances to gain capital strength and access
to broader customer bases. Such global trends are
found in India, with the exception of consolidation.
The Indian banking system is still in the growth
phase. The impulses of consolidation are not yet seen
in private banks and much less so in PSBs whose
policies originate from the Government. Even the
merger of one PSB with another that took place five
years ago in the early period of banking sector reforms benefited neither bank.
The increasing forays of banks into new areas
and convergence of business operations of banks,
DFIs, and NBFCs raise the issue of merging banks,
based on specific business complementarities. Mergers would be determined by the size of the balance
sheet, or by efficiency, competitiveness and strategic repositioning to reduce intermediation costs, expand delivery platforms, and to operate on econo-
RECAPITALIZATION
The Government owns the core of the Indian banking sector, a factor that has contributed to its quick
recovery from capital shortage. It did not need to
adopt the complicated procedures observed in the
rehabilitation processes of Japan and Korea to inject
public funds into major banks. The Government even
helped the nationalized banks increase their CARs
(Table 21).
Table 21:
Capital Contributions by Government
to Nationalized Banksa (Rs billion)
Item
Amount
Up to March 1992
1992/93
1993/94
1994/95
1995/96
1996/97
1997–February 1998
Total
Capital Returned to Government
Net Contribution
33.00b
7.00c
57.00c
52.87b
8.50c
15.09c
27.00
200.46
6.43
194.03
a Including New Bank of India
b Capital contribution.
c Capital allocation.
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associate banks to expand in their respective regions.
Such a policy may accelerate improvement in the
population per branch ratio and also productivity.
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Source: Reserve Bank of India.
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mies of scale. The Government is disinclined to urge
mergers whereas RBI wants market forces to decide.
In the corporate world, 50 percent of mergers fail
due to cultural incompatibility of the two organizations coming together. The Government in 1996/97
favored merging banks to create megabanks of international size and competitiveness. The only merger
that materialized was five years ago between ICICI
(a DFI) and the financially ailing Imperial Tobacco
Company (an NBFC of the multinational: ITC). ICICI
had the incentive of a tax shield advantage in addition to expansion into retail business and a network
advantage. But the resulting merger was widely regarded as unsuccessful for both parties.
Mergers of international banks are being evolved
to develop synergy and worldwide international competitiveness. Indian banks have a long way to go in
this regard. The country has a lot of small banks not
interested in the global market, for they lack the required expertise. They need to remain focused on
doing what they do best—understanding their local
market base. The danger is that of becoming too
specialized, because when business drops, the difficulties start. Banks need to diversify. In the right
place and with the right focus, there is room for big
multinationals and small private banks operating within
a country. A smooth merger may be possible among
the eight state banks because of their 50 years of
staffing and management homogeneity, while small
private banks may be forced to merge to remove
diseconomies of scale.
Consolidation will remain a matter of theoretical
discussion at least until after the merger of New Bank
of India with Punjab National Bank has been studied. The problem of weak PSBs is a separate one.
Banks that were nationalized in 1969 had a regional
branch network and influence before nationalization.
Instead of mergers, they should be given freedom to
expand their branch network in regions of their choice
to facilitate relocation of staff that were rendered
surplus due to computerization. SBI has allowed its
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THE INDIAN BANKING SECTOR: ON THE ROAD TO PROGRESS
Recapitalization has been going on since 1991 in
line with the implementation of the recommendations
of Narasimham Committee (I). The total amount of
net contribution of the Government to the nationalized banks up to February 1998 was Rs194.03 billion, which was 5.5 percent of total assets as of March
1997. Needless to say, this recapitalization of the
nationalized banks has been supported by India’s taxpayers.
Additionally, some PSBs issued equity or subordinated debt to increase CARs. Three nationalized
banks (Dena Bank, Bank of Baroda, and Bank of
India) raised capital of Rs17.05 billion through public
issues. In contrast, four PSBs obtained capital by
85
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The Narasimham Committee (II) recommended a
restructuring commission as an independent agency
to run weak banks to restore them to operational
health over a period of three to five years. Also, such
banks should operate as “narrow banks,” i.e., deploy
only deposits for investment in Government securities. The recommendations ignore that the weak
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?
BANK RESTRUCTURING
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Restructuring Commission for
Weak Banks
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issuing subordinated debt. However, the precise figure of the amount of capital derived from the subordinated debt is not available.
This process of bank recapitalization was guided
by the Indian authorities because the Government
and RBI are major holders of PSBs. Thus, in theory,
there should exist no conflict between shareholders
and the regulatory authorities that monitor the process on behalf of depositors and other debt holders.
This conflict sometimes complicates and hinders the
process of disposing of distressed banks in a fully
privatized banking industry, such as that in countries
like Japan.
The public issues by PSBs suggest that the Indian
Government believes that bailout of such banks
through capital injection is costly. However, according to the recapitalization figures of nationalized banks,
the Government has not yet abandoned the policy of
restricting interface of PSBs with the capital market. It will take a long time for the capital market to
play a pivotal role in monitoring and disciplining bank
managements in India.
Meanwhile, the shortage of capital seems to be
getting worse in the cooperative bank sector although
the expert committee organized by NABARD recommends that the stringent capital adequacy norm
should be extended to cooperative banks and RRBs.
The committee recommends that the Government
rescue program should be quickly implemented to
assist cooperative banks to achieve 4 percent capital
adequacy level by the end of March 1999.
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A STUDY OF FINANCIAL MARKETS
?
86
(public sector) banks are old banks and they should
be dealt with according to causes of deterioration
such as mismanagement, lack of supervision, and
political interference.
The Government and RBI instituted restructuring
exercises for weak banks detected based on the
implementation of recommendations of the Narasimham Committee (I) in 1992/93. There are only three
PSBs (India Bank, United Commercial Bank, and
United Bank of India) that still require treatment.
What has gone wrong with these banks is well known
and remedial measures should lie with individual banks
according to the nature of their respective sickness.
Since investment in Government securities now carries risk weight, narrow banking may not be the correct solution.
The weak banks must improve the bottom line of
each branch by adding earning assets. In the absence of these, they may end up with “one-legged
managers,” i.e., who know only how to raise deposits (liabilities) but are averse to risk management (of
assets). These banks are too big and rationalization
or closure of branches is not going to mitigate their
major weaknesses. A long-term solution will lie only
in financial strengthening and efficiency. Since mergers with the strong banks have been ruled out, the
Government as the owner must stand by these banks
while firmly rooting out bad managers and deficiencies. Restructuring does not have fixed rules and has
to be bank specific, depending on several factors, as
follows:
• importance of the banking system to the economy,
• methods for developing institutional arrangements,
• maturity of society, and
• political system.
Redimensioning (i.e., downsizing) by closure of
branches will go against India’s development objective of reducing the population-branch ratio. The much
neglected cooperative banking sector cannot fill the
increasing service delivery gap for a population that
is rapidly rising.
ASSET RESTRUCTURING COMPANY
Operational Efficiency
The most important problem facing Indian banks is
how to improve their operational efficiency.
Overall efficiency of the banking sector may be
measured by an index of financial deepening defined
by the ratio of total bank deposits to GDP. This index
increased substantially between the 1970s and the
mid-1980s (see Table 22). The improvement can be
partly explained by the expansion of the branch network in India.
Table 22:
Financial Deepening
Year
Deposits/GDP (percent)
1970
1975
1980
1985
1990
1991
1992
1993
1994
1995
1996
13.4
18.0
27.8
33.6
35.7
36.9
38.4
39.1
39.6
36.2
38.3
GDP = gross domestic product.
Source: IMF, International Financial Statistics, various issues.
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The Union Finance Ministry is considering asking
the strong PSBs to set up an ARC for the weak
banks who have problems in recovering their bad
loans.
It is proposed that the debt funding of ARC be
through the issuance of Government-guaranteed
bonds. Although the Finance Ministry has not yet
taken a final decision on the modalities of an ARC,
an internal study on establishing an ARC is being
worked out.
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Developmental banking remains the need of the country and the Government should concretely demonstrate the will to back the risk-taking ventures of
banks. The ability of public sector banks to raise equity from the markets will depend upon how Government chooses to back the banks. An asset reconstruction fund (ARF) is a solution that will favor bad
banks while penalizing good ones.
The current thinking is that an ARF would be
formed for weak banks with equity contribution from
PSBs. This would amount to withdrawing equity from
such banks in times when they have to meet stringent CAR deadlines. It is the weak banks and their
borrowers who must struggle to reform the balance
sheet. Debt recovery processes in India are tortuously lengthy and ARF will not deliver goods better
than the banks and their particular branches out of
which funds have been lent.
Unlike the banking crises in Asia, Latin America,
or the savings and loans problem in the US (in 1989),
Indian banks’ NPA problem was not caused by excessive risk concentrations. The real sector (which
has been buoyant in Asia) has not undergone structural changes to be internationally competitive and
Indian banks have remained at the receiving end.
PSBs should seek conversion of nonpayable debt
obligations of the defaulting borrowers into equity
and line up cases for sale/mergers. What banks can
do in this respect, ARF will not be able to do. Instead, a lot of time will be wasted in finding equity
for ARF and assembling NPA assets from banks
for transfer to ARF. The need is to reform the real
sector and also to develop preventive controls in
banks.
The weak PSBs owned by the Government are
of the “too big to fail type” and have been in existence for nearly a century. The critical policy initiative should be to reform and recapitalize them instead of relieving them of bad debts through an ARF
vehicle.
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?
ASSET RECONSTRUCTION FUND
?
THE INDIAN BANKING SECTOR: ON THE ROAD TO PROGRESS
However, in spite of the branch network expansion, financial deepening still remains at a low level
(less than 40 percent) by global standards. The Indian financial deepening index is slightly higher than
those of the PRC and Viet Nam at the beginning of
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Increasing public ownership of banks will require
management to prudently handle shareholder constituencies since takeovers by speculators wanting
to make easy money or ensure financing for their
own businesses are among the potential risks. This
task lies squarely in the domain of the regulator and
corporate offices of banks. Banks as business organizations have to match up to both social expectations and stakeholder aspirations. The board of a bank
bears a principal responsibility for fashioning a governance code appropriate to its structure. It is also to
be charged with the responsibility of subjecting the
code to a periodic review to make it contemporary in
a multibusiness banking organization.
The fundamental factor that has brought boards
of directors into the spotlight is a lack of confidence
in their system of accountability. The second factor
that has focused attention on corporate governance
is the emergence of the global market. In the search
for attractive investment opportunities, the major institutional investors have moved beyond their domestic markets and are looking to spread their risks geographically. As they do so, they demand high and
consistent standards in terms of both financial reporting and the treatment of shareholders’ interest,
making boardroom accountability and standards of
corporate governance a global issue.
There are, however, no uniform global standards
of corporate governance. Nevertheless, these standards are moving forward and this is gradually leading to a greater degree of convergence between
markets. No company can afford to ignore these
developments, which are underpinned by advances
in information technology (IT) that make information about companies more widely and immediately
accessible, thus contributing to the unification of financial markets. This also very much applies to the
players in banking and other financial sectors.
Bank Computerization
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The issue of autonomy concerns mainly PSBs and
DFIs. Autonomy as a concept can be summarized
as follows:
• it calls for separation of ownership and management;
• it requires distinction between bureaucracy and
business management. In terms of accountability, this means distinguishing between performance accountability and accountability for misfeasance;
• it necessitates change in the mindset of bankers
as well as regulators;.
• banks have to ready themselves to exercise autonomy. This requires creation of knowledgeable
workers who can bring to bear upon the functioning of the bank at all its establishments the
collective wisdom of the management;
• autonomy is an inevitable fallout of deregulation;
• government or regulatory scrutiny does not
amount to “back seat driving” and does not deprive a good management of its autonomy; and
• where Government/RBI directives concern procedural aspects in place of performance scrutiny through results, then banks may suffer the
phenomenon of “back seat driving.”
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Autonomy and Governance
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their respective market reforms. This suggests that
there is plenty of room for the Indian banking sector
to increase its presence in the financial system.
Commercial banks in India will also have to service the demands of the different economic segments.
They must not ignore nor prefer to serve only one of
these at the expense of the others. Banking services
have to be designed and delivered in response to the
wide disparity in standards and ways of living of rural, semi-urban, urban, and metropolitan populaces.
For example, the banking needs of a vast majority of
the Indian population residing in the rural and semiurban areas are relatively simple. In these markets,
availability of services, timely credit, and low cost of
their delivery are needed.
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A STUDY OF FINANCIAL MARKETS
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88
Entry of new private sector banks, PCBs, and foreign banks offering most modern technology bank-
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ing has forced PSBs to address computerization problems more seriously in recent years. The pace of
computerization has remained slow even though opposition from staff unions has softened. The Central
Vigilance Commission wants 100 percent computerization in Indian banks to check frauds, delays, etc.
The general perception is that in recent years, the
prime focus of bank computerization has been less
on the number of branches computerized but more
on better connectivity, say, between the head office
and regional offices of a bank with select branches.
These are usually banks that handle large corporate
borrowing accounts on one side, and those that are
in high deposit zones, on the other.
While the private sector banks have been upgrading technology simultaneously with branch expansion, many of the top PSBs have completed automating their branches in the urban areas. The next
step to total branch automation is networking these
branches. PSBs need to frame a strategy to choose
the branches that have to be included in their networking scheme. Since it would be a daunting task
for them to connect all the 64,000 branches spread
across the country, as a first step, they are following
the 80-20 thumb rule. It assumes that 80 percent of
bank’s business is carried out by only 20 percent of its
branches. It is the branches with substantial business,
most of which lie in the urban areas, that are initially
targeted for interconnection.
A major problem PSBs have to face once IT implementation reaches its optimum level is staff retention. While the private sector banks have been recruiting trained and experienced IT professionals, it
may not be possible for PSBs to do likewise. They
will have to train their existing staff to function effectively in the new environment. And once the requisite skills are acquired by employees, they may have
trouble retaining staff. PSBs can only allocate limited capital resources to computerization. They will
have to choose between high cost of computerization at metro and urban centers and low cost computerization at rural, semi-urban branches. Also, they
?
THE INDIAN BANKING SECTOR: ON THE ROAD TO PROGRESS
will have to factor in returns on IT assets, and growth
and productivity improvements.
Newly opened private sector banks, foreign banks,
and a few other Indian banks have started Electronic
Money activities, which open up business opportunities but carry risks that need to be recognized and
managed prudently. The Basle Committee on Banking Supervision has raised issues of critical importance to banking authorities in this regard. There is
no evidence that these aspects are being looked into
in India, yet there is a need for auditing firms to be
aware of this issue.
Despite recapitalization, the overall performance
of PSBs continues to lag behind those of private sector and foreign banks. Questions of ownership, management, and governance are central to this issue.
Under public ownership, it is almost impossible to
draw a distinction between ownership responsibility
and managerial duty. For this reason, Governmentowned banks cannot insulate themselves from interference. Inevitably, some PSBs are overregulated
and overadministered.
A central concern is that banking operation flexibility, which is essential for responding to changing
conditions, is difficult to implement. Under public control, the efficiency objective in terms of cost, profitability, and market share is subordinated to the vaguely
defined public interest objective.
Moreover, it is not only difficult to inject competition between PSBs since they have a common ownership, but Government-imposed constraints have
also meant that they have not been able to effectively compete with private sector banks. India still
has to find a middle path of balancing divergent expectations of socioeconomic benefits while promoting competitive capitalism.
Political sensitivities can make privatization difficult but the Government aims to bring down its holdings to 51 percent. When that happens, a great stride
will have been completed. In 1998, announcements
have been made on corporatization of IDBI and reduced Government holdings in Bank of Baroda, Bank
89
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branch” criterion is the yardstick that is routinely used
to measure the adequacy or otherwise of banking
facilities in regions that have been demographically
demarcated as follows: rural (population below
10,000), semi-urban (population between 10,000 and
100,000), urban (population between 100,000 and
1 million), and metropolitan (population above one
million).
Dividing the total population by the number of bank
branches, the population per branch has fallen from
64,000 in 1969 to 15,000 as of June 1997. This does
not take into account, however, staff redundancies
likely from computer-based banking including the
spread of automated teller machine (ATM) outlets.
Even in the most advanced branch banking and computerized banking environments such as Canada, the
ratio of population to branch is only 3,000 and if ATM
banking is included as branch-type retail outlet, the
ratio is still lower. In India, foreign banks are fast experiencing staff redundancy and aging problems but
not allowed to branch out freely into places requiring
competition, especially in foreign trade financing.
The Government needs to expand the branch network to ensure a reduction in the population per
branch ratio further to 10,000 (phase I), 5,000 (phase
II), and 3,000 (phase III) by including, if necessary,
ATMs and similar outlets as branches at metro and
urban centers.
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It would be worthwhile for RBI to reward banks
through a special subsidy for spreading a credit card
culture on the basis of the number of credit cards
and annual transition volumes. The largest bank, SBI,
did not even have a credit card until the formation of
its joint venture with GE Capital in 1998/99.
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SPREAD OF CREDIT CARD CULTURE
NARROW BANKING
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RBI currently uses only demographic data for issuing branch licenses. The “population served per
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REGIONAL SPREAD OF BANKING
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Branch investment and reengineering is often the
responsibility of operations or premises departments
with little regard for coordination with marketing departments. In order to maximize the benefits of
branch investment or reengineering, astute management teams should integrate all aspects of their brand
and its customer interface under identity management to harness the power of the bank
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INTERDEPARTMENTAL COORDINATION
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PSBs and the rural banking system have to build up
the transaction and advisory services of their
branches. In a competitive marketplace, a retail
branch environment that can project and deliver the
brand promise has become increasingly important.
As retail banks undertake strategic reengineering
of distribution and delivery strategies, product and
service enhancement and network downsizing, they
ignore the role of the branch and the power of a
brand at their peril, since the branch is a retail bank’s
shop window and platform for differentiating its products and services.
With the growth of automated transactions, the
role of the branch is changing and must reflect new
marketing and brand communication strategies. Is
the branch to be a retail opportunity drawing customers for financial services advice, or is it an outpost of technology and remote transaction efficiency?
Can the branch network provide both? The answers
lie in the strength, depth, and clarity of an
organization’s brand identity, which is the foundation
upon which a retail bank can communicate its unique
product or service.
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BRAND IDENTITY
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Importance of Branches
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of India, Corporation Bank, Dena Bank, IDBI, Oriental Bank of Commerce, and SBI.
?
A STUDY OF FINANCIAL MARKETS
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90
Weaker banks have been under pressure to cease
lending and concentrate on investments in Government securities, which are subject to depreciation
risks. Narrow banking is therefore not a solution for
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quired skills and actual requirements is increasing as
more complex product mixes are introduced and traditional banking products are replaced. Another reason is the skewed age profile of employees, some of
whom were taken on 30-35 years back when the
branch expansion programs started.
Indian banks are highly unionized and productivity
benchmarks are not clearly established. To create a
more constructive work attitude, the disinvestment
or privatization programs of PSBs should include share
offerings to staff, an idea successfully carried out by
SBI, Bank of Baroda, and Bank of India, among others. The spread of computerization (so far inhibited
by staff union pressures on quotas and wage hikes)
must be evaluated in terms of return on information
technology assets of the banks and revised productivity benchmarks.
Another issue requiring attention is regular recruitment in various grades every year, since experienced
employees in banking are built up over several years.
An embargo on recruitment since 1985 has skewed
the age profile of the workforce in PSBs. Such imbalances are difficult to rectify. There are those who
argue for productivity-linked wages, which is a dangerous recipe in the context of a unionized workforce.
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The number of bank management staff and employees in India is vast (223,000 in SBI; 81,252 in SBI
Associates; 581,000 in nationalized banks; 57,241 in
old private sector banks; 1,620 in new private sector
banks, and 13,510 in foreign banks operating in the
country). The total is 957,623, with the number of
staff employed in cooperative and rural banks equally
large. Potentially, the gap between availability of re-
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LABOR UNION AND HUMAN RESOURCES
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Human Resources Issues in Banking
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Table 23 shows the Indian banks’ low coverage of
bills and receivables financing, and low level of exposure of bank clientele to the foreign trade segment. Partly these should be ascribed to a lack of
banking services or expertise of centers where demand for the services exists but is met by distantly
placed branches. Inadequate bills and direct receivables financing results in underutilization of network
branches through which collections can take place.
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Credit Delivery System
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weak banks. Enhancing the branch network can improve the bottom line and should be explored. Such
banks require all-round restructuring.
?
THE INDIAN BANKING SECTOR: ON THE ROAD TO PROGRESS
?
Distribution of Outstanding Credit of Scheduled Commercial Banks According to Type of Account,
March 1996 (percent)
No. of
Accounts
Credit
Limit
Amount
Outstanding
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Type of Account
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Table 23:
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Cash credit
Overdrafts
Demand loans
Medium-term loans
Long-term loans
Packing credit
Export trade bills purchased
Export trade bills discounted
Export trade bills advanced
Advances against export cash incentives and duty drawback claim
Inland (Trade) bills purchased
Inland (Trade) bills discounted
Inland (Others) bills—purchased
Inland (Others) bills—discounted
Advances against important bills
Foreign currency checks/TCs/DDs/TTs/ MTs purchased
Total
Amount (Rs billion)
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DD = demand draft, MT = mail transfer, TC = travelers check, TT = telegraphic transfer.
Source: Reserve Bank of India.
16.1
6.8
7.2
24.8
42.9
0.5
0.3
0.1
0.1
0.0
0.4
0.3
0.2
0.1
0.1
0.2
100.0
4,767,771.0
35.7
7.7
7.9
9.4
18.9
7.3
3.2
2.1
1.1
0.1
1.3
2.4
0.9
0.8
0.8
0.4
100.0
2,684.4
35.7
7.4
8.0
10.3
19.8
7.0
2.6
1.8
0.9
0.1
1.2
2.2
0.9
0.7
0.8
0.4
100.0
2,184.4
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What is needed is fair competition, merit-based career progression policies, strong management of staff,
and transparent performance evaluation systems (experience of international banks paying proprietary rewards and packages for specialist traders, etc., have
not exactly been happy since such staff have landed
some banks with losses).
The merger of banks as recommended by Narasimham Committee (II) to create strong banks that can
compete internationally can result only in the creation
of formidable union power and amplify inefficiencies.
Policies are also needed to prevent significant turnover of banking staff in cities, urban as well as semiurban and rural branches. Incentives must be given to
staff in rural and semi-urban branches to increase motivation and minimize fast personnel turnover.
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A STUDY OF FINANCIAL MARKETS
Priority Sectors
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The Chief Vigilance Commission in 1999 has clarified that banks should be 100 percent computerized
by the year 2000 and that bank unions will have no
say in this matter. This is to ensure that frauds, which
have reached serious proportions under the manual
processing system, are kept in check. The area of
computer fraud, however, is not addressed.
Foreign banks have started reducing staff under
the Voluntary Retirement Scheme. Such packages
for staff of weak PSBs remain under discussion.
Table 24 shows the number of staff deployed in
scheduled commercial banks (SCBs), and the number of deposit accounts and borrowing accounts
handled. As can be seen from the table, improvements must be made in branch service operations,
staffing, and expansion in rural and semi-urban SCBs
considering the high volume of banking transactions
and the relatively smaller number of staff per branch
compared with urban/metropolitan SCBs.
Indian banks have been assigned an important public
role of allocating financial resources to specified priority sectors, a system that has contributed to the
creation of assets, a green revolution, and a white
5
revolution, apart from strengthening the base of
small-scale industries. The level of NPAs should not
detract policymakers from supporting banks’ roles
in the development of the priority sectors. A fair,
objective assessment of socioeconomic benefits is
needed. Branch expansion in unbanked areas will
have to continue to create wealth and prosperity. The
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For the first time, the Government, RBI, and IBA
have ruled out a uniform wage increase formula
that is not linked to banks’ productivity and performance. Across-the-board pay hikes blur the distinction between good and bad performers while
operating costs continue to mount. About 80 percent of the operating expenses of PSBs are accounted for by wages and salaries. RBI data on
bank intermediation cost (BIC) ratios show that
PSBs in the period 1991-1998 recorded an average
rise in the BIC ratio, in contrast with Indian private
sector banks, which managed to hold the ratio down.
The only way forward now is for banks to be left
free to genuinely compete.
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WAGE HIKES
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Number of Offices, Deposits and Borrowing Accounts, and Staff in Scheduled Commercial Banks
(inclusive of regional rural banks), as of March 1996
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Table 24:
32,981
13,731
9,798
7,946
64,456
196,031
227,039
595,955a
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Amount of
Deposit Accounts
(Rs million)
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No. of
Staff
Amount of
Borrowing Accounts
(Rs million)
Staff/
Branch
Deposit/
Branch
Borrowing/
Branch
?
Branch Location
No. of
Branches
1,019,025
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112.9
109.4
88.5
81.2
392.0
Sources: Reserve Bank of India, Indian Banks Association.
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a Includes metropolitan staff.
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Rural
Semi-urban
Urban
Metropolitan
Total
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92
28.8
15.9
7.0
4.9
56.7
6
17
34a
3,423
7,968
9,028
10,224
873
1,158
718
621
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remained a long haul, though the amounts required
are much smaller than those received by sponsor
banks themselves by way of recapitalization. A largescale merger would force an appropriate recapitalization, which entails only a one-time cost to the taxpayer instead of a continuous annual invisible cost
load.
Traditionally rural and semi-urban areas have been
looked upon as requiring help and lacking in competent management. This mindset in policy formulation, regulations, and procedures governing the rural
banking system has left the rural system ailing, as
was revealed during recapitalization/restructuring
exercises on RRBs, which had operated under ad6
verse regulatory constraints. Liberalization of RRBs’
activities has permitted them to participate in more
profitable businesses. A single, strong, merged RRB
setup would bring to the rural economy a well-directed banking apparatus to take care of infrastructure, export financing, and traditional businesses.
This will require better management or setting up
new RRB branches in district locations and state
capitals, regional boards, and a central board for operational policy governance. Such a bank should be
charged with developing linkages between rural and
urban centers to provide commercial banking services and not merely rural finance. Agricultural product exports are increasing, establishing the need for
new services even at rural and semi-urban level.
Unfortunately, post-reform thinking has dampened
the will of nationalized banks to serve such needs.
Reform proponents have advocated pruning of priority sector credit from 40 to 10 percent for PSBs
without considering how cooperative banks and
RRBs can fill the void that may be created by withdrawal of major players from the activity.
CLEARING SYSTEM REFORM
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RRBs (accounting for 30 percent of the branch network of SCBs) are prime candidates for merger to
create a single large rural-oriented outfit with a commercial approach and competencies.
PSBs perceive RRBs as a drag on the system.
Although RRBs sponsored by different banks are
fragmented outfits, their staff unions have successively fought and secured wage parity with the staff
of sponsor banks. As a result, there is a weak rural
banking system of branches with highly paid staff
instead of the original plan to create “barefoot bankers.” RRBs as small banks will remain fragile and
their recapitalization (Rs3.64 billion added so far to
the Rs1.96 billion of the earlier paid-up capital) has
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POSITION OF RURAL BANKS
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Rural Banking
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economic reforms cannot be molded to leave 60-70
percent of the country’s population with only a trickle
down effect from reforms.
The shackles of “directed lending” have been removed and replaced by the criteria of merit and commercial viability. Also, expansion in the definition of
priority sector, upgrades in value limit to determine
SSI status, and provisions for indirect lending through
placement of funds with NABARD and SIDBI have
lightened the performance load of banks. SSI and
export financing take place more in metro and urban
areas in a competitive environment. As such, priority sector financing is no longer a drain on banks.
There is also a need to simplify reporting formats
and cutback on paperwork. This can be done by dividing bank capital for metro/urban areas branches and
rural/semi-urban area branches, and imposing the discipline of the CAR and CAMELS model for internal
performance evaluation at regional offices supervising such branches. The cooperative banking segment
also needs urgent recapitalization support since its
entire market and client base is in the priority sectors.
Priority sector financing is a continuing priority
for survival of banks with large networks of rural
and semi-urban branches.
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THE INDIAN BANKING SECTOR: ON THE ROAD TO PROGRESS
Industrial location policy requires that apart from
notified industries of a nonpolluting nature, new industries must be set up beyond the 25 kilometer radius of any city with a population of more than
93
FRAGILITY OF NONBANKING FINANCIAL
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Nonbanking Financial Companies
COMPANIES
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Simple personal computer (PC)-based computerization of rural and semi-urban branches would cost
about Rs1.8 billion (cost of PC [Rs40,000] X No. of
branches [45,000]), or about $43 million for PSBs.
The business of these branches is largely retail and
better control on priority sector loans at these
branches requires equipment upgrades. Staff training and system upgrades at these branches would
have to follow.
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COMPUTERIZATION
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NABARD has a statutory supervisory role over 28
state cooperative banks, 364 district central cooperative banks, and 196 RRBs. It also exercises voluntary supervision over 19 state-level and 738 primary-level agricultural rural development banks by
virtue of its refinancing and developmental role. An
Expert Committee set up by NABARD in January
1998 recommended a comprehensive package of
reforms, including extending the capital adequacy
norm to cooperative banks and RRBs gradually within
a period of five years and three years, respectively.
The committee noted that a large number of cooperative banks (66) and RRBs (170) were debilitated
and not in a position to meet even the minimum capital requirements because of heavy erosion of assets.
In order to improve the prudence of bank management, the internal auditing system must be
improved systematically, for instance based on
CAMELS rating model.
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SUPERVISION
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one million. While this has forged close economic links
and sparked a daily flow of banking transactions between city and rural bank branches, the latter are not
admitted to the city’s clearing house facilities. Check
collection and related banking services are, as a result, riddled with delays, slowing down the circulation
of money and adding to the amount of paperwork,
interoffice transactions, and risk of fraud. Expansion
of city clearing systems will radically simplify banking
and reduce transaction costs of rural branches.
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A STUDY OF FINANCIAL MARKETS
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94
Unlike in other Asian economies, the nexus between
banks and NBFCs in India is not significant. From
1985 when mutual funds and merchant banking expanded, RBI emphasized that there should be an
“arms’ length” relationship between banks and their
affiliates. This “Chinese Wall” is stronger now than
ever before.
Private market lenders are considered to have
stronger incentives or greater ability to monitor borrowers, and better positioned than public creditors to
renegotiate contract terms or exercise control rights
in the event of problems.
While banks and finance companies are equally
likely to finance problematic firms, the latter tend to
serve riskier borrowers, particularly those who are
more leveraged. This is important for a country such
as India, where nationalization of banks has, in many
instances, diluted the informality that lower class of
borrowers prefer. NBFCs and informal credit markets have thrived on lack of interest in this field among
the PSBs and expanded their asset base, fed on appetite for deposits at high rates.
With strict capital adequacy, income recognition,
and NPA norms in the offing and with the SSI sector
remaining at the receiving end of the economic slowdown problems faced by large corporates, too many
restrictions on NBFCs will create only a void in the
credit chain that banks cannot fill. Like small private
sector banks and primary urban cooperative banks,
NBFCs have their place in the financial system and
this should not be subject to sweeping changes by
regulators. If depositors looking for high deposit rates
are willing to take risks, there is no need for them to
be cautioned, except in cases of frauds and misfeasance. NBFCs operate in different market segments
with relevant marketing strengths such as in leasing,
hire purchase, factoring, merchant banking, car financing, transport financing, and home financing. They
have different risk profiles as well as asset-liability
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Factoring Services
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Several companies and SSI units are often exposed
to credit risks on sales but do not have the required
competencies in receivables portfolio management.
Banks providing working capital finance do not give
adequate attention to default risks and the quality of
receivables. On the basis of recommendations of a
Government Committee on economic reforms (1985),
the system of factoring was looked into by another
committee, and factoring companies were set up as
subsidiaries by banks such as SBI and Canara Bank
in 1992. In February 1994, perhaps to give further
impetus to the factoring system, RBI directed that
banks will also have the option to undertake the activity departmentally, though at select branches of
the banks since factoring services require special
7
skills and infrastructure.
Aside from the four basic factoring services of
administration of the sellers’ sales ledger, provision
of prepayment against the debts purchased, collection of debts purchased, and covering the credit risk
involved, factoring companies can also provide certain advisory services to the client by virtue of their
experience in credit and financial dealings and access to extensive credit information.
Credit information services are highly deficient in
India and there is little sharing of information among
banks. As a financial system combining all the related services, factoring offers a distinct solution to
the problems posed by working capital tied up in trade
debts, more than 70 percent of which arise in Indian
businesses by virtue of selling “on account (A/C)
terms of payment.” This is a large volume over which
Indian banks have had poor control. Bankers are relatively slow in responding to this important aspect of
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working capital finance management.
Policy Recommendations
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NBFCs will remain important as the Government has
tasked them to retail the sales of Government securities to the saving public. Moreover, the public will
need their services in all other areas not touched by
banks. Like banks, NBFCs may have to develop a
second tier money market in which borrowing/lending will automatically come under “credit limit” and
“credit watch” discipline of the players in similar lines
of business. Temporary cash flows must therefore
find safe, acceptable investment avenues in the second tier money market. Entities such as mutual funds
will welcome this. The gain on the whole will be
market-regulated functioning of NBFCs.
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NEED FOR INTER-NBFC MONEY MARKET
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composition. It is not pragmatic to club them together
to be subjected to a strait-jacketed regulatory regime.
RBI announced guidelines for NBFCs in January
1998. Among other things, the directives linked the
quantum of public deposits that can be accepted by
NBFCs directly to their credit rating, and the excess
deposits held were required to be repaid before 31
December 1998. The result was panic among the
public. RBI has since then modified the rules but
there is no assessment so far as to how many NBFCs
will be deemed as unviable.
Credit rating is a relatively new field in India and
public awareness of the nuances of credit rating grades
remains poor. NBFCs are mainly deposit-taking companies and a depositor has no way to secure liquidity
in the midst of a possible downgrade. Credit-rating
agencies already have their hands full with corporate
rating business and it is doubtful if NBFCs operating
in remote corners of the country can achieve ratings
to satisfy their depositors and RBI. And it is also unlikely that all NBFCs can be effectively regulated and
inspected by RBI, as the cost would be out of proportion to the risk to be controlled. The best way out for
the public affected by the dilemma would be to identify priority centers where bank branches should be
opened as alternate service providers in place of
NBFCs ceasing to operate or forced to close down.
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THE INDIAN BANKING SECTOR: ON THE ROAD TO PROGRESS
Some major issues are highlighted on the problems
of the Indian banking system arising out of the discussion so far, and quoting, where relevant, Narasimham Committee (II) recommendations.
95
PROBLEM OF THE REAL SECTOR VS.
BANKING SECTOR REFORMS
Strengthening the viability of the real sector is important for improving Indian banking and the financial system as a whole, which is but an institution to facilitate
effective transmission of policies and smooth flow of
resources within the economy. The Committee on Capital Account Convertibility has not dwelt on the impact
to the real sector of expected inflow of capital in relation to efficiency and absorptive capacity of that sector.
In short, the future of reforms will have to focus
on how the real sector and banking sector strengthen
each other.
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necessary, change in the guidelines and accounting
system should be immediately undertaken.
Banks must adopt methods of converting debt into
equities in NPA accounts whenever possible to either ensure turnaround in corporate performance or
sell equities to limit future losses. Today banks do
not have an exit route.
Analysis of NPAs needs to be carried out not only
with reference to sectoral dispersal of NPAs but also
to specific accounts of NPAs that are common in
balance sheets of banks and AIFIs, to bring about
harmonization of their recovery efforts. Among banks
and AIFIs, research into cases handled by Credit
Guarantee Schemes, Export Credit Guarantee Corporation and state-level institutions as well as by BIFR
should help to crystallize core problems of lending
systems and problem areas of economic activity.
PROVISIONS
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RBI should not relax NPA norms in response to a
slowdown in the economy. For prudential norms relating to income recognition, it should adopt the
Narasimham Committee (I) recommendation to
gradually shorten norms from 180 to 90 days for incomes that stop accruing to be classified as NPAs.
Asset quality improvement should take place by
tightening norms for classifying assets from substandard to the doubtful category. The downgrading of assets in the Indian system is lax as the move
from substandard to doubtful category is made only
if it is past due for 30 months or remains in the
substandard category for 24 months. This has to be
improved upon. Also, the quantifiable criterion for
defining a weak bank should be: accumulated losses
+ net NPAs exceeding the bank’s net worth. Payment defaults by borrowers are mainly due to neglect of the receivables portfolio of their current
assets, a reason why banks ought to seriously launch
factoring and receivable portfolio management services to improve velocity of receivables and the
overall credit quality.
Net NPAs have to be brought down to below
5 percent by 2000 and to 3 percent by 2002. However, banks with international presence should reduce gross NPAs to 5 and 3 percent by 2000 and
2002, respectively, and net NPAs to 3 and 0 percent
by the same period.
As discussed previously, RBI guidelines stipulate
that interest on NPAs should not be charged and
considered in the income account. The guidelines
create some complications in the accounting system.
For instance, if a loan has turned into an NPA shortly
before the end of a financial year, the interest payments during that and the previous financial years
are considered not yet earned and the corresponding
book entries recognizing interest income should be
reversed. The definition of income recognition has
become a critical issue in presenting a clear picture
on the profit/loss account of banks. A review and, if
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ASSET CLASSIFICATION
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Nonperforming Asset Management
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A STUDY OF FINANCIAL MARKETS
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96
Prudential norms requiring general provision of at
least 1 percent on standard assets must be established. Also, the general provision should consider
potential loss assets determined through historical
accounts. International banks practice different general provision standards and these should be examined. General provision should also include tax holidays to be granted as an incentive to banks, to accelerate strengthening of their capital base.
Regulation and Supervision
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to “substandard”, and vice versa, as a measure of
the quality of management.
The Indian system of governance (in the public
and private sectors) has long fostered a climate of
resistance to bankruptcy and also a tendency to provide bailouts that distort the risk. As such, the reform process will be a long haul. The sequencing
may not be perfect and will necessitate adjustments.
Restructuring will also be required separately for institutions remaining in difficulty. Real sector reforms,
especially in terms of international auditing standards,
accounting, timely and accurate information to markets, and good governance practices, must be aggressively pursued to support improvements in the
soundness of the financial system.
REGULATORY FRAMEWORK
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There should be consolidation of balance sheets of
different entities of banks to reveal their strength and
to disclose connected lendings, pattern of assets and
liabilities (domestic and foreign) in different maturities, and NPAs. Some banks overseas are required
to publish cash flows, a practice Indian banks have
started. The disclosure should also include migration
patterns of asset classification, e.g., from “standard”
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Disclosure, Accounting Framework,
and Supervision
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Raising interest rates and reflating the economy
through increased Government expenditure must be
avoided. The risks to the banks and financial institutions come from NPAs that may be generated by a
continued industrial slowdown. Thus, NPA management can be carried out by maximizing attention to
the extent of credit concentration and considering
diversification of credit portfolios through consumer
financing, housing loan provision, factoring, and agricultural and SSI financing.
Management of NPAs should also focus on improving management culture that permeates various
organization levels instead of being restricted to concerns on recovery, capital adequacy, and accounting
processes. The NPA problems and their consequences will need to be assessed on the extent of
mismanagement, including fraud.
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MANAGEMENT
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FOCUS ON NONPERFORMING ASSET
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A risk weight of 5 percent should be applied to
investments in Government and other approved securities to hedge against market risk. Also, the entire
portfolio should be marked to market in three years.
Other non-SLR investment assets of banks need to
be brought in line with risk weights assigned to loans
and advances.
A 100 percent risk weight must be applied to foreign exchange open positions. Gap management is
needed to correctly reflect foreign exchange risk
exposure.
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THE INDIAN BANKING SECTOR: ON THE ROAD TO PROGRESS
The Narasimham Committee (II) suggested that the
“Basic Core Principles of Effective Bank Supervision” be regarded as the minimum to be attained.
Banks must be obligated to take into account market
risk weights to foster a sound and stable system.
For RBI to effectively carry out its monetary policy,
delineation of supervision/regulation from monetary
policy is required. The executive associated with
monetary authority should not be in the supervision
board, to avoid weakening of monetary policy, or
banking regulation and supervision. The separation
of the Board of Financial Supervision (BFS) from
RBI has to be initiated to supervise the activities of
banks, FIs, and NBFCs. A new agency, the Board
for Financial Regulation and Supervision (BFRS),
would have to be formed. To bring about integrated
supervision of the financial system, the Narasimham
Committee (II) recommended putting urban cooperative banks (UCBs) within the ambit of BFS and
proposed prudential and regulatory standards besides
new capital norms for UCBs.
The Narasimham Committee (II) recommended
amendments to the RBI Act and Banking Regulation Act with regard to the formation of BFRS. It
97
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The likely conflict between monetary policy and supervisory concerns can be taken as the basis and the
rationale for combining the two functions. Separate
authority structures for the two functions have more
likelihood of coming into conflict with each other.
The regulatory and supervisory systems have to take
into account peculiarities of the banking and financial structures. For instance, India’s RRB structure
is vast, its cooperative movement quite strong, but
banks in this sector are generally quite weak.
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SEPARATING SUPERVISION
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The BIS Tripartite Group agreed that the term “financial conglomerate” should be used to refer to “any
group of companies under common control whose
exclusive or predominant activities consist of providing significant services in at least two different financial sectors [e.g., banking, securities, insurance].”
Many of the problems encountered in the supervision of financial conglomerates arise when they offer not only financial services, but also nonfinancial
services and products. Coordination between RBI,
Insurance Regulatory Authority, and SEBI is increasingly urgent.
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REGULATION OF FINANCIAL CONGLOMERATES
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also gives more autonomy and powers to PSBs (Nationalization Act). As the changes in the legal framework affecting the working of the financial sector
sought by the Narasimham Committee are wide ranging, an expert committee could be constituted.
Regulation and supervision have been strengthened through prescriptions that include the establishment of a statute for BFS. Independence and autonomy of BFS would not be impaired by being a
part of RBI. What is important is autonomy for the
RBI and dilution of Government ownership in banks.
Some legislative action may be needed to support
the banking regulatory framework reforms. The reform issues should be examined by research institutions dealing with banking concerns.
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A STUDY OF FINANCIAL MARKETS
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98
Creating equal opportunities for banks and FIs has
been slow. As a result, financial packaging and closure of projects (term loans and working capital)
suffer. Progress on this structural reform has to be
constantly monitored. IDBI, ICICI, and IFCI should
move toward acquiring banking licenses to provide
one-stop services. Since the 1960s, there has existed an unnatural divide between term-lending functions and working-capital finance. The solution lies
in putting in place stringent credit monitoring in which
banks and FIs should share their expertise and information.
There is no need for a super regulator as rec9
ommended in 1998/99 by the Khan Committee,
which examined harmonization of roles/functions
of banks and FIs. RBI should remain the sole regulator to ensure that the financial system is well
supervised and that the risks of the real sector do
not get transmitted to the financial sector by default. The current worries about strengthening of
the financial system stem more from the industry’s
lack of transparency, corporate governance standards, and accountability to shareholders. Requiring disclosure for quarterly results is changing this
situation and making the information flow to investors more orderly. This requirement applies now
to banks and FIs that have raised public money.
Consequently, tightening of the financial system will
be accelerated.
In 1998/99, the World Bank issued a directive that
international audit firms cannot put their name to
accounts of Indian companies that are not in line with
high quality international financial reporting standards.
Standards are indeed low but implementing the World
Bank directive would not be practicable without Government legislation on standardization of various reporting systems and their incorporation into the Companies Act. The Government has to quickly remove
these bottlenecks to boost investor confidence, attract foreign direct investment, and minimize damages to the financial sector.
TRADING RISK MANAGEMENT
The trading portfolio of banks in India is becoming
more diverse with a range of bonds, equities, and
derivatives available, and RBI permitting investments
in overseas markets. Debt swaps and interest rate
swaps as well as currency swaps are entered into
with foreign banks and such exposures need special
monitoring. There is an eagerness to introduce a variety of derivatives but the regulatory and risk management apparatus is not fully ready.
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unless banks introduce factoring, the legitimate bank
credit needs of such borrowers will remain unmet.
Deficiencies of Indian bills and money markets have
persisted despite reports by high-level committees
during the late 1980s. The quality of receivables continues to be unsupervised and securitization is still a
remote possibility.
INTERNAL AUDIT MACHINERY AND COMPLIANCE
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In order to promote bill culture and the secondary
market, RBI directives require borrowers to resort
to bill financing to a minimum of 25 percent of receivables. Most borrowers, especially among SSIs,
find compliance difficult and it is not known how many
are forced to forgo financing from banks and resort
to market borrowings. The “on account payment”
invoicing is the dominant trade practice in India and
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BILL CULTURE
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In general, the development of ALM operations has
to be in the direction of an objective and comprehensive measurement of various risks, a pursuit of returns commensurate with the size of the risk, and a
strategic allocation of capital and human resources
based on the risk. The evolution in financial management with the sophistication of ALM operations has
to be an autonomous response and not driven by regulators.
As banking and financial sector reforms have been
under way in India for the last six years, the only
factor that could affect their balance sheets is lack
of ALM in terms of maturity and interest rate mismatches. Banks will have to participate actively in
forming money markets and to enforce data generation at each branch level. RBI, in its Monetary and
Credit Policy Review (30 October 1998), announced
the introduction of interest rate swaps but these will
be used only when banks discover the extent of mismatches that cannot be cleared through term-money
markets.
With respect to “off-balance sheet” assets, there
will be a need to create a corporate level knowledge
base in banks about items that offer “price risk transferring” or “credit risk transferring” or both opportunities. Examples of the former are swaps, futures,
options and loan caps, forward rate agreements, and
credit enhancing guarantees. Credit risk transferring
opportunities include letters of credit and note issuance facilities.
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FOCUS ON ASSET LIABILITY MANAGEMENT
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Asset Liability Management
?
THE INDIAN BANKING SECTOR: ON THE ROAD TO PROGRESS
There are dangers in banks’ practice of cosmetic
cleaning or “evergreening” of advances to prevent
10
NPAs. In 1996/97, the Jilani Committee observed
that banks’ internal audit machinery and compliance
are weak. RBI stipulates that audit committees of
boards should seek to ensure management’s commitment to internal audit control. This can be made
stronger by stating that internal audits are management’s reporting responsibility to stockholders. The
internal auditing system should be established by training bank inspectors and rotating their assignments.
With regard to computer audits, SBI and IBA have
been doing work in this area since 1987. Computer
audit skills are lacking even in India’s chartered accountant firms. It is worth having computer audits as
a statutory requirement. In the US, the Federal Reserve and FDIC have jointly issued manuals on electronic data processing audit on the grounds that “technology changes the way business is done in banks.”
The computer audit of computer service agencies
by banks employing them is mandatory (with respect
to outsourced work).
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pact of reforms initiated in the first phase. But as the
reforms were introduced in stages, it is too early to
assess their impact. What has been achieved is transparency with respect to banks’ financial statements,
bringing Indian accounting standards closer to internationally accepted norms. One discernible impact
has been that all but two PSBs (Indian Bank and
United Commercial Bank), had met by 31 May 1997
the capital adequacy norm of 8 percent and some
are already well above that threshold. For instance,
that for SBI is 14.58 percent; UBI, 10.86 percent;
BOI, 9.11 percent; DenaBank, 11.88 percent; and
IDBI, 13.7 percent. The weaknesses that have
emerged in the banking system are in fact weaknesses of the prereform period. The issues to be tackled in the second phase of reforms are large and
cannot be delayed because the adjustment process
would become increasingly difficult. As far back as
1961, RBI advised banks to aim for a CAR of 6
percent (of paid-up capital and reserves to deposits)
because they had been increasing their assets without a corresponding augmentation in the capital base.
This ratio declined from 9 percent in 1950 to 4 percent in 1960, and 1.5 percent in 1978.
Mergers and Recapitalization
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A capital adequacy of 9 percent should be achieved
by the year 2000 and 10 percent by 2002. This goal
should be weighed against the expected financial
support from banks for economic growth and protection of risk assets. In the first phase of reforms
(1991-1997), banks changed their approach from
“growth budgeting” to “balanced growth budgeting”
(i.e., with reference to their own funds). The dilemma
of banks’ shortage of capital to cope with increasing
credit demand must be resolved as a priority so that
capital adequacy does not become an end in itself.
Measures should not be implemented in isolation.
If the capital adequacy levels are being brought to
international levels, then the concept of a tier-3 capital should also be introduced, i.e., as a subordinated
debt instrument (of shorter maturity of two years)
much like the bonds issued towards tier-2 capital (of
five years maturity).
Other measures to strengthen banks should seek
to eliminate the management dilemma. This can be
done if banks themselves internalize a culture of selfevaluation under the CAMELS model by undertaking periodical management audits. The core message of capital adequacy and prudential norms is selfregulation.
Measures to be taken in the second phase of banking reforms should be based upon a study of the im-
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Capital Adequacy
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Certification of Information Systems Auditors
(CISA) examinations from the US are now available in India, but few bank staff take them. Banks’
inspectorates and chartered accountant firms should
have CISA qualified auditors.
Similarly, banks, nonbanks, and companies require
professionals qualified in handling foreign exchange
trading. In fact, RBI has taken the lead to define risk
management standards in PSUs that take on foreign
exchange exposure.
There is also a need for professionals qualified to
carry out securities and stock market trading in all
the market intermediaries.
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A STUDY OF FINANCIAL MARKETS
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100
The Narasimham Committee recommended that after the activities of DFIs and banks have converged
for a period, the DFIs should be converted into banks,
leaving only two types of intermediaries—banks and
nonbanks. While mergers between strong financial
institutions would make sense, the weak banks in the
system would have to be given revival packages.
The licensing of new private sector banks needs to
be reviewed, while foreign banks will have to be encouraged to extend their operations.
The importance of the tasks ahead is underlined
by the fact that Government recapitalization of nationalized banks has cost Rs200 billion. SBI has been
an exception particularly because it has addressed
(since 1974) the task of reflecting its financial strength
through the building of reserves. This is due to the
FISCAL IMPLICATIONS
All bank restructuring attempts have fiscal implications that are bad if considered in isolation. The advantage lies in taking on the fiscal impact and not
allowing problems to fester. The Government should
draw up a total balance sheet of bank nationalization
and socioeconomic gains to strengthen PSBs, on
which it will have to depend if it is to reduce the
11
population/branch and ATM ratio from 15,000 to
3,000.
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Bank Restructuring
ASSET RECONSTRUCTION COMPANY
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requirement to raise lines of credit in the international market for itself and for Indian corporates. SBI
has done this regularly for some years since 1972. It
was late in establishing offices overseas but quickly
caught up with international standards of management. One factor that has helped SBI has been the
private shareholdings held in it even after 1955 when
RBI acquired a majority share. As a result, SBI has
been required to hold annual general meetings of
shareholders and has benefited from the system of
checks and balances, disclosure disciplines, and dividend expectations of shareholders.
With most nationalized banks incurring continuous losses since 1992/93, returns on capital have been
negative, preventing buildups of reserves. Slow accretion in reserves was also due to higher provisioning requirements under the new prudential norms.
With the Government no longer willing to provide
further capital, the only route for PSBs to improve
their capital base is through substantial improvement
in generation of internal surplus so as to be in a presentable shape to approach the capital market. These
features and the weaknesses of the rural banking
system should determine the measures required in
the second phase of reforms.
Government-guaranteed advances that have turned
sticky should be classified as NPAs and, in cases where
sovereign guarantee argument is advanced, there
should be appropriate disclosure in the balance sheet
of banks. Potential for conversion of such loan assets
into Government debts in the form of securities issued
to banks should be looked into as a way of removing
contamination from banks’ balance sheets. This way,
a loan asset in a bank’s balance sheet would be transformed into an investment asset.
The measure would not only help to clean up bank
balance sheets but also strengthen the Government’s
resolve to eventually sell off or privatize the business
units for which the Government provided a guarantee to a bank. This will in turn contribute to an improvement in the recovery climate.
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THE INDIAN BANKING SECTOR: ON THE ROAD TO PROGRESS
The Government should not provide capital support
or indirect financing to ARCs. The Narasimham
Committee (II) recommended that there should be
no further bank recapitalization other than the undisbursed amount of Rs4 billion from the previous
budget provision that can be diverted as seed capital for ARCs. ARCs will be required for banks that
are not viable over a three-year period. Such banks
will have to be referred to the Restructuring Commission.
The Narasimham Committee proposed the establishment of ARCs to tide over the backlog of
NPAs. Banks would undertake financial restructuring by hiving off their NPA portfolios to ARCs
and obtaining funding from it through swap bonds
or securitization. But the Indian banking sector does
not require any emergency policy for rebuilding,
despite the NPA problem. The only banks that need
to be recapitalized in the near future are some rural
and cooperative banks. The dangers of ARCs are
obvious since it could prove to be an easy route for
commercial banks to clean up their balance sheets,
creating scope for staff to repeat mistakes instead
of learning from them.
Banks have managed recoveries and creation of
ARCs would only reverse the healthy recovery of
management systems that banks are hoping to establish.
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Systems and methods in banks should be improved.
Some of the issues are at the micro level and best
achieved if banks internalize the system of self-evaluation under the CAMELS rating model.
Banks also need to effectively exploit their networks of branches established in the past at low cost.
It is necessary for PSBs to introduce factoring services and also activate a short-term bill financing
mechanism, both of which entail utilization of the
branch network for collection of the factored invoices
and bills for clients.
Autonomy and Governance
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The private sector’s partial ownership of SBI has
contributed to its exceptional operational efficiency
even after 1955 when RBI acquired majority shares.
This suggests that it is advisable in the long term for
the Indian banking sector to increase the share of
private ownership.
In order to reduce the social burden caused by banking sector inefficiency, banks should be given wider
management autonomy. The Government should gradually but steadily reduce its ownership of the banking industry while maintaining rigorous prudential
regulation and rationalizing its supervision capacity.
To bring about efficiency in banks, the Narasimham
Committee (II) recommended a number of measures.
These included revision and regular update of operational manuals, simplification of documentation systems, introduction of computer audits, and evolution
of a filtering mechanism to reduce concentration of
exposures in lending and drawing geographical/industry/sectoral exposure norms with the Board’s concurrence. Besides, the Narasimham Committee suggested the assignment of full-time directors in nationalized banks. As outsourcing of services would
improve productivity, it recommended that the same
be introduced in the fields of building maintenance,
cleaning, security, dispatch of mail, computer-related
work, etc., subject to relevant laws. It also suggested
that the minimum stipulated holdings of the Government/RBI in the equity of nationalized banks/SBI be
reduced to 33 percent.
With regard to the tenure of a bank’s chief executive, the Narasimham Committee indicated a minimum period of three years. However, a more reasonable length of tenure should not be less than five
years. Managers should be given incentives to adapt
their managerial structure to new developments in
financial technologies and to changes in client demand for financial services. The Government needs
to seriously consider an increase in management
autonomy in the banking industry, because it is essential to efficient management.
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Operational Efficiency
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A STUDY OF FINANCIAL MARKETS
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102
Autonomy and sound governance are likely to be
achieved after privatization of banks has taken place.
The Narasimham Committee’s observation that most
banks do not even have updated instruction manuals
proves the point. RBI’s selection of statutory auditors for banks may seem to conflict with the requirement for sound corporate governance. However, such
regulatory intervention will remain useful until banks
can fully strengthen their internal systems and procedures, risk management standards, and the required
preventive and detective controls.
Recruitment and workforce management as well
as remuneration management should be left for banks
to handle. But apart from exceptional cases, this is not
a priority area. Although the problem of overstaffing
is a legacy not easy to get rid of, it has been halted
since 1985/86 through restrictions in fresh recruitment.
All appointments of chairpersons, managing directors, and executive directors of PSBs and financial institutions should be determined by an appointment board. The Narasimham Committee felt that
there was an urgent need to raise competency levels
in PSBs through a lateral induction of talented personnel. It also indicated that the remuneration structure should be flexible and market driven.
The Government should quickly take steps to induct shareholder nominees on banks who have raised
money from the public but do not have representation on the boards.
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There are several institutes and colleges that provide skills- and management-oriented training programs to staff every year. Some are dedicated to
individual banks, while a few institutes cater to the
needs of all Indian banks and FIs. However, there
is only one institute that conducts professional ex12
aminations—the Indian Institute of Bankers, which
has completed 70 years of service to the banking
industry in the country. It develops professionally
qualified and competent bankers through examinations and continuing professional development programs.
Recognizing that the trend throughout the world is
to acquire proficiency in management through Master of Business Administration (MBA) degrees, the
institute has signed a memorandum of understanding
with the Indira Gandhi National Open University, New
Delhi, to offer an MBA in Banking and Finance. This
program will enable a practicing banker to bridge
professional experience with academic excellence.
Banks need to encourage the attainment of relevant
professional qualifications among staff, and the
institute’s activities are steps in the right direction.
Analysis of NPA management in banks has revealed that instruction manuals in most banks are
not up-to-date. Audit systems concerned with exercise of preventive and detective controls cannot be
effective in such an environment, while training systems will lack a proper foundation. RBI should assign proportionate punitive negative ratings to banks
for such deficiencies. The Narasimham Committee
(II) has also called for the updating of manuals in
banks. Another area of training should concern codes
of ethics and public accountability.
Reduction in Priority Sector Loans
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Human resources are not merely an asset but the
real capital of a bank. Banking in the future will require knowledgeable workers. A bank should have a
group of chief officers in a variety of fields so that
the collective wisdom of their organization is at the
fingertips of every employee. An integrated body of
knowledge and professionalism in banking has to be
in place to ensure continued financial viability. Staff
morale plays a crucial role in developing good organizational culture. In that context, training is going to
be an important factor.
Resuming recruitment of young trainees, training
and retraining of personnel, accelerated promotions
for young people through competition, studious habits, strong staff management, matching resources with
emerging responsibilities, developing backup support
to determine recruitment needs of new skills, and
spread of an IT culture are among the issues that
have to be addressed. The focus should be to create
core competencies for handling various types of risks
and customer sophistication, to meet all needs, from
rural to urban.
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Human Resources Development
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It will also have to reorient economic governance
to ensure that transaction costs to the public, trade,
industry, and financial sectors are reduced or eliminated. For example, in 1998, the Government released
an autonomy package for nine more PSBs (totaling
14 as of 31 March 1998), which result in the elimination of consultations and delays in decision making.
A step further would be to install regional boards for
PSBs in order to delegate power and improve operational governance. Centralization has built rigidities, fostered mediocrity, and curbed bank expansion
in the rural and semi-urban areas. If the Government’s plan to computerize all branches is to be
achieved, capital will be required that can be found
only through cost cutting which itself is dependent
on decentralization. Nationalized banks need to have
regional boards of directors like SBI to decentralize
decision making.
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THE INDIAN BANKING SECTOR: ON THE ROAD TO PROGRESS
Both Narasimham Committees recommended that
the directed credit component needs to be reduced
from 40 to 10 percent since contamination of banks’
balance sheets has come from payment defaults in
this sector. With more disintermediation and competition coupled with rising costs and falling income
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margins in metro and urban centers, more than 70
percent of the branch network of PSBs situated in
rural and semi-urban areas should look upon local
market opportunities as being a “priority” for the
banks themselves. These areas are rich in potential,
which banks can tap only if they can introduce technology and computerization at relatively low investment costs. Banks’ neglect in this area explains to
some extent the growth of the informal sector and
NBFCs. Yet the farming community in many states
today is well educated and needs modern banking
support, which neither foreign banks nor newly
opened private sector banks would offer.
According to data quoted in the R. V. Gupta Committee Report (April 1998) on agricultural credit
through commercial banks: “There has been an increase in the flow of credit to the agricultural sector
from Rs112.02 billion by all agencies in 1991/92 to
Rs286.53 billion in 1996/97, and to an estimated
Rs342.74 billion in 1997/98. This has been possible
on account of more refinance extended by NABARD
to rural financial institutions, RBI’s increased support by way of general line of credit to NABARD
for the short term, and introduction of special agricultural credit plans by commercial banks for this
sector. RBI has played a central role in motivating
commercial banks to place a special emphasis on
agriculture. In spite of these initiatives, there is a
perception that investments in agriculture have not
kept pace with demand.”
There is a need to review the best banking practices that brought prosperity to rural and semi-urban
areas. The causes of decline should be isolated and
tackled.
Most of the factors causing NPAs in the priority
sectors can be brought under control. The priority
sectors include SSI financing, which is handled prominently at bank branches in metro and urban areas
(not only in rural and semi-urban areas) and is commercial except that it is under priority credit. By the
same argument, agriculture financing in rural and
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A STUDY OF FINANCIAL MARKETS
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104
semi-urban areas is equally a commercial proposition. As such, the calculation of contamination coef13
ficient of directed credit requires review and should
not lead to policies that curtail financing to important
economic segments. Most important, a rural banking
system under control of NABARD is too weak to
shoulder the burden of rural credit.
The Government and banks interpret the term
“directed” as “targeted” in reference to the Narasimham Committee (I) recommendation for a “directed credit allocation to the priority sector.” The
shift in focus should be towards timely and adequate
credit to eligible borrowers. The “service area approach” introduced in 1987 that allocated command
areas to rural banks restricted the choice of bank
for borrowers and choice of borrowers for banks
that allocated command areas to rural banks. The
freedom to manage advocated by Narasimham
Committee (II) warrants abandonment of this “service area approach.”
Freedom also should exist for reporting performances in lending to agriculture with reference to
harvest periods instead of using a fixed date of
31 March, which is the banks’ balance sheet date,
when demand for agriculture credit is depressed.
The Gupta Committee has identified core human
resources problems such as staff of rural/semi-urban branches commuting daily from places where
their families can stay comfortably. Lack of recognition of performance at such branches by their senior
management is another problem.
The issue of merging RRBs to create a single rural-oriented banking institution deserves support since
recapitalization of more than 140 sick RRBs has still
not been decided. Also, capital infusion into cooperative banking is long overdue. This contrasts
sharply with the urgency with which nationalized
banks received a large amount of recapitalization
support from the Government. India cannot have a
strong banking system only for metro and urban services if it wants to be globally competitive.
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In the wake of computerization of banks, the management challenge concerns staff redundancies.
Branch expansion in rural and semi-urban areas
would be a logical way to deploy the excess staff.
Some 600 million people (out of a population of more
than 900 million) live in these areas. The populationbranch ratio of 12,000 on a gross basis needs to be
reworked separately for rural and semi-urban areas
(making allowance for good communication and
transportation networks that are available in metro
and urban areas) and improved significantly. Economic liberalization since 1991/92 has failed to fully
bring forth the “trickle down” benefits to the rural
and semi-urban poor and has instead resulted in high
investment in the luxury goods sector. The bias should
be corrected by boosting Government investment in
rural infrastructure and expanding banking activities.
RRBs are presently under the control of four
regulators: the sponsor bank, state governments,
NABARD, and indirectly RBI (under a system of
consolidated supervision to which the parent bank of
the RRB is subjected). A single countrywide entity
merging 196 RRBs of more than 14,000 branches
(functioning in 23 different states and 435 districts)
could end this fragmentation and develop a focused
system. This system could mobilize a large volume
of deposits through active management and low-cost
technology to achieve a reduction in transaction costs,
have its own dedicated training system, establish internal controls, regionalize supervision and audits,
create payment networks by having branches at each
district under which present rural branches of any
RRB fall, and provide timely, need-based credit at
each rural area.
More than 14 countries have benefited from “Project Microbanker,” a customized version of which
can be used by RRBs. Alternatively, software can
be developed that will be feasible and cost effective
if RRBs are amalgamated. A nationwide payment
and remittance system at rural level is necessary
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RURAL BANKING AND SMALL INDUSTRIAL CREDIT
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Rural Banking
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THE INDIAN BANKING SECTOR: ON THE ROAD TO PROGRESS
because there has been a regular migration of people
from different states as farm laborers and industrial
workers and these need remittance services.
Amalgamation will result in creation of a strong
national rural banking apparatus if commercial orientation and management upgrades are also tackled
alongside recapitalization. Such a large bank should
have branches at districts and state capitals to foster
strong links between these centers and outlying rural
areas where the majority of RRB branches operate.
Besides creating a strong nationwide payment network, it would achieve harmonization of policy and
growth strategies—especially in agriculture and agroindustry exports for which adequate services are not
available from commercial banks (centers where the
business potential is high). The amalgamation of
RRBs could take place through four to five subsidiaries; i.e., groups of RRBs in contiguous regions,
or by having a single amalgamated bank structure
with regional boards and a central board based on
the SBI structure.
The Government has introduced a Rural Infrastructure Development Fund, which is administered
by NABARD, for financing state governments. Perhaps a strong commercial rural-oriented banking vehicle can deliver better results.
Currently, RRBs are standalone institutions with
branches functioning in a highly adverse and isolated
environment. A centralized institution of RRBs by
merger could attract better managerial talent and also
take its cues from the corporate sector and multinationals, which regard the rural economics of India as
potentially a fast developing market. In fact, some
corporates and multinationals today are engaging
MBA degree holders qualified in rural development
subjects. Some rural areas are potential candidates
for development into export centers for which modern banking facilities should be made available, instead of making the customers commute to urban
centers to meet their international banking needs.
There are other justifications for merging RRBs
into a single unit. It is true that the merger of weak
105
Nonbanking Financial Companies
The NBFC reform agenda is complex because of
the large number of NBFCs, their locational spheres,
varied composition of assets and liabilities, failure rate,
and incidences of fraud that have caused a loss of
depositors’ confidence. There are also new requirements of credit rating, capital adequacy, statutory liquidity, and registration with RBI. In many areas,
there might be forced or voluntary closures of NBFCs
that are not able to comply with the norms. RBI
should identify such places and ask banks to open
branches to provide alternatives to depositors where
none exists.
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ral banking system will have to develop this. Profits
from agriculture produce are heavily dependent on
infrastructure and market information. Market information system is the key to development of infrastructure for rural markets. The system would include all information regarding prices, investments,
manufacturing, and requirements of all products. The
Government National Information Centers have a
big database in each state, but market-oriented use
and the sharing of it with banks are required.
Factoring Services
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units cannot build strength but the merger will attract
the required attention to the system in which the scope
for synergy is high. The risk of putting RRBs in the
same club as cooperative banks is that the method
of supervision fails to distinguish the ownership
pattern and differences between the two sets.
NABARD should benefit from realignment of its
supervisory load if RRBs are merged and provided a
strong central management. This rural banking apparatus can create competition, which is absent totally in the rural banking field. RRBs are already permitted to invest in shares and debentures and units
of mutual funds up to 5 percent of their incremental
deposits. All RRBs, if merged, could generate a sizable corpus of funds and also management competencies to handle such an investment portfolio, which
today each RRB has to separately develop.
The Narasimham Committee proposed that the
operation of rural financial institutions be reviewed
and strengthened in their appraisal, supervision, follow-up loan recovery strategies and development of
bank-client relationships, in view of the higher NPAs
in PSBs due to directed lending. With regard to CAR,
RRBs and cooperative banks should reach a minimum of 8 percent over five years. Also, all regulatory and supervisory functions over rural credit institutions should rest with the proposed BFRS.
Banks would have to offer financial solutions to
the agricultural sector and put to use expertise in
private equity, venture funding, and corporate finance
to tap the potential of agri-based businesses in
14
India.
Banks and corporates as well as cooperatives will
have to take into account changes in consumer attitude toward processed food and modernize the distribution and retail systems. There should be proper
advisory services, project financing, venture capital,
strategic and private equity and asset financing—
including off-balance sheet financing—to come up
with investments in this sector. Though India is the
third largest producer of fruits and vegetables in the
world, it lacks a market information system. The ru-
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A STUDY OF FINANCIAL MARKETS
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106
Factoring services have not taken off even though
they improve velocity of receivables, thus affording
better credit control. Only three important factoring
systems have been established, namely, SBI, Canara
Bank, and SIDBI. Experience of existing factoring
companies in India is that average credit period of
receivables is cut by more than 25 percent resulting
in cost reduction of working capital. The rigorous
follow-up by factoring companies also decreases
debt delinquency.
Application of electronic data interchange (EDI)
needs to be progressively adopted to accelerate
growth of factoring services. Banks, corporates,
medium-size industries, and SSIs should unite to develop electronic message formats in receivable portfolio management and collection systems.
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Universal Banking
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Current account convertibility (CAC) is not going to
benefit Indian banks, which still have to get to grips
with the full-scale convertibility on current accounts
in force for the last few years. At the macroeconomic level, there are two aspects that merit special
attention: India’s external debt is now close to
$100 billion; and it has a strong parallel economy
(black market), which can weaken its balance of
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Capital Account Convertibility vs.
Banking Sector Vulnerability
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External sector development, particularly with respect
to trade, should continue to be a major concern if
stable growth is to be encouraged and economic competitiveness enhanced.
If export performance does not improve, the consequences for the banking and financial sectors might
be serious. External assistance to the export sector
should be extended by multilateral agencies through
the Indian banks and FIs. During 1989/90, the World
Bank extended loans to Indian banks to finance export projects and to allow repayments to be retained
as equity for banks. This should be undertaken again
in the current and future financing activities of multilateral loan institutions.
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External Sector
payments in a CAC type of regime. The Government should improve its utilization of aid funds and
foreign capital rather than just basing economic
growth requirements on free capital inflows (which
cannot be obtained unless outflows are freed).
Indian banks need to become competitive with
branches of foreign banks in centers where both exist,
and the number of such centers ought to be enlarged
to promote modernization in Indian banks. There is
no risk of Indian banks being dislodged from their
prime position in the home market if more branches
of foreign banks open at important centers nor can
their foreign branches become internationally competitive since capital that Indian banks can spare for
foreign branches is marginal and low.
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The adoption of EDI will allow computer-to-computer exchanges of business transactions such as
purchase orders, invoices, shipping notices and other
standard business correspondence between trading
partners. Exporters and importers as well as domestic traders can translate all foreign or domestic traderelated documents electronically without any human
intervention from their own premises, drastically reducing paperwork and increasing efficiency. Even
though measures are being taken to increase exports
and earn foreign exchange, the nonimplementation
of EDI is proving to be a major obstacle to boosting
exports because many countries carry out trade
transactions mostly electronically.
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THE INDIAN BANKING SECTOR: ON THE ROAD TO PROGRESS
Caution must be applied on universal banking because of the following considerations:
• disintermediation (i.e., replacement of traditional
bank intermediation between savers and borrowers by a capital market process) is only a decade old in India and has badly slowed down
due to loss of investor confidence;
• there is ample room for financial deepening (by
banks and DFIs) since loans market will continue to grow;
• DFIs as holders of equity in most of the projects
promoted in the past have never used the tools
advantageously;
• DFIs are now only moving into working capital
finance, an area in which they need to gain a lot
of experience and this involves creation of a network of services (including branches) in all fields:
remittances, collections, etc.; and
• reforms of India’s capital market is still at the
halfway stage. The priority will be to ensure
branch expansion, financial deepening of the
credit markets, and creation of an efficient credit
delivery mechanism that can compete with the
capital market.
107
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The Narasimham Committee recommended that
banks and primary dealers alone should be allowed
in the interbank call and notice money market.
NBFCs would get access to other forms of instruments in the money market such as bill rediscounting, commercial papers, and T-bills. It also suggested
opening the T-bill market to FIIs to broaden its base.
The imperfections of money market lie in the traditional nomenclature used; for instance, the “call
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Money Market
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A STUDY OF FINANCIAL MARKETS
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108
money market,” which, instead of allowing clearance
only of temporary surpluses and deficits, is actually
treated as a source of regular funding by banks (particularly foreign banks). The need is to remove the
word “call” from various reports and publications of
RBI and define it clearly as a composite money market for call funds and term funds. There is little activity in the term funds market even though the liability structure of banks and DFIs has undergone a considerable transformation.
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ment leasing, hire purchase finance, and factoring services
would also be covered within the above exposure ceiling.
Banks undertaking factoring services departmentally
should carefully assess the clients’ working capital needs
taking into account the invoices purchased. Factoring
services should be extended only in respect of those invoices that represent genuine trade transactions. Banks
should take particular care to ensure that by extending
factoring services, the client is not overfinanced. No worthwhile progress has taken place, reflecting apathy of banks
towards factoring.
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9RBI constituted in 1997 a working group under the chair-
manship of S. H. Khan, Chairman of Industrial Development Bank of India, to (i) review the roles, structures and
operations of development finance institutions (DFIs) and
banks in the emerging operating environment; (ii) suggest measures for bringing about harmonization in lending and working capital finance by banks and DFIs; (iii)
examine scope for increased access to short-term funds
by DFIs; and (iv) strengthen organization, human resources, and related issues of DFIs and banks in the prospect of introduction of capital account convertibility.
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of banks, RBI felt the need for a review of existing systems
for which a working group under the chairmanship of
Rashid Jilani, chairman of Punjab National Bank, was set
up in 1996. The committee made several important recommendations, which RBI accepted and directed banks to
follow.
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10To strengthen internal audit and inspection machinery
11ATM is deemed as a branch, being a service provider.
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12The main objectives of the institute are as follows:
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advances and should accordingly be given risk weight of
100 percent for calculation of capital-to-risk-asset ratio.
Further, the extant guidelines on income recognition, asset classification, and provisioning would also be applicable to them.
Abank’s exposure shall not exceed 25 percent of the banks’
capital funds to an individual borrower and 50 percent to a
group of borrowers. The facilities extended by way of equip-
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7These activities should be treated on par with loans and
the chairmanship of Dr. Sukhamoy Chakravasti to review
the workings of the monetary system. The report of this
committee provided several directions to the future shape
of financial sector reforms. Among its various recommendations, the Committee advocated stricter credit discipline
and a reduction in the importance of cash credit, greater
resort to financing of working capital through loans, bills,
and receivables.
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than recognizing that rural banking promoted since 1969
up to 1991 has transformed several poverty regions to
high levels of prosperity.
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6The mindset is loaded with concerns over poverty more
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producers.
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5Production of milk. India is among the world’s biggest
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The accumulation of and age of cases remaining undisposed are large and recovery suits filed by banks lie in the
queue. The Reserve Bank of India’s Health Code Scheme
in the 1980s impelled segregation of loan assets by quality of bank balance sheets, which until 1992 (when the
formal reform process started) showed a rosy picture. Banks
did not take full advantage of the Health Code classification with the result that bad borrowers got an extended
breather to saddle banks with loss assets.
8The Government appointed in 1985 a committee under
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4India’s judges/people ratio is the lowest in the world.
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quent upon enactment of the Recovery of Debts due to
Banks and Financial Institutions Act of 1993 (pursuant to
recommendations of Narasimham Committee ) but have
not made much impact on recovery performance of banks.
The number of DRTs has remained inadequate with disposal of cases slow, as gathered from data recorded in
para 2.95 of RBI Report on Trends and Progress of Banking in India, 1997-1998. DRTs are known to have functioned with multiple states jurisdiction and inadequate
infrastructure, a reason why the Working Committee on
DRTs was set up in 1998 by RBI/Government to look into
the related problems.
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3Debt Recovery Tribunals (DRTs) are established conse-
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2The ordinance came into effect on 31 October 1998.
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SBI were formerly Imperial Bank of India, Ltd. and Major
Princely State Banks, respectively. It is legally prescribed
that RBI must hold at least 55 percent of SBI.
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1The State Bank of India (SBI) and Associate Banks of
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Notes
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THE INDIAN BANKING SECTOR: ON THE ROAD TO PROGRESS
• to encourage the study of banking and institute a system of examinations, certificates, scholarships, and prizes;
• to promote information on banking and related subjects
through lectures, discussions, books, correspondence
with public bodies and individuals, or otherwise; and
• to collect and circulate statistics and other information
relating to the business of banking in India.
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the future market size of India’s basic food sector as
follows: dairy, $11 billion; animal feed and poultry,
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14 A McKinsey & Company/Faida Report estimated
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(II) report.
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13See p. 25, paragraph 3.31 of the Narasimham Committee
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A STUDY OF FINANCIAL MARKETS
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110
$10 billion; wheat milling and processing, $6 billion;
and beverages, $4 billion by 2005. There would emerge
the concept of “large market high growth segment” for
India and the need for the development of larger food
and agriculture companies and necessary funding arrangements.
doc_391791451.pdf
The banking system in India is significantly different from that of other Asian nations because of the country's unique geographic, social, and economic characteristics. India has a large population and land size, a diverse culture, and extreme disparities in income, which are marked among its regions.
The Indian Banking Sector
On the Road to Progress
G. H. Deolalkar
G. H. Deolalkar is formerly Managing Director of State Bank of India.
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tries, exports, and banking activities in the developed
commercial centers (i.e., metro, urban, and a limited
number of semi-urban centers).
The banking system’s international isolation was
also due to strict branch licensing controls on foreign
banks already operating in the country as well as
entry restrictions facing new foreign banks. A criterion of reciprocity is required for any Indian bank to
open an office abroad.
These features have left the Indian banking sector with weaknesses and strengths. A big challenge
facing Indian banks is how, under the current ownership structure, to attain operational efficiency suitable for modern financial intermediation. On the other
hand, it has been relatively easy for the public sector
banks to recapitalize, given the increases in
nonperforming assets (NPAs), as their Governmentdominated ownership structure has reduced the conflicts of interest that private banks would face.
Financial Structure
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The banking system in India is significantly different
from that of other Asian nations because of the
country’s unique geographic, social, and economic
characteristics. India has a large population and land
size, a diverse culture, and extreme disparities in income, which are marked among its regions. There are
high levels of illiteracy among a large percentage of
its population but, at the same time, the country has a
large reservoir of managerial and technologically advanced talents. Between about 30 and 35 percent of
the population resides in metro and urban cities and the
rest is spread in several semi-urban and rural centers.
The country’s economic policy framework combines
socialistic and capitalistic features with a heavy bias
towards public sector investment. India has followed
the path of growth-led exports rather than the “exportled growth” of other Asian economies, with emphasis
on self-reliance through import substitution.
These features are reflected in the structure, size,
and diversity of the country’s banking and financial
sector. The banking system has had to serve the goals
of economic policies enunciated in successive fiveyear development plans, particularly concerning equitable income distribution, balanced regional economic growth, and the reduction and elimination of
private sector monopolies in trade and industry. In
order for the banking industry to serve as an instrument of state policy, it was subjected to various nationalization schemes in different phases (1955, 1969,
and 1980). As a result, banking remained internationally isolated (few Indian banks had presence
abroad in international financial centers) because of
preoccupations with domestic priorities, especially
massive branch expansion and attracting more people
to the system. Moreover, the sector has been assigned the role of providing support to other economic sectors such as agriculture, small-scale indus-
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The Banking Sector
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Overview of Banking and
Financial Institutions
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A STUDY OF FINANCIAL MARKETS
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60
The Indian financial system comprises the following
institutions:
1. Commercial banks
a. Public sector
b. Private sector
c. Foreign banks
d. Cooperative institutions
(i) Urban cooperative banks
(ii) State cooperative banks
(iii) Central cooperative banks
2. Financial institutions
a. All-India financial institutions (AIFIs)
b. State financial corporations (SFCs)
c. State industrial development corporations
(SIDCs)
3. Nonbanking financial companies (NBFCs)
4. Capital market intermediaries
About 92 percent of the country’s banking segment
is under State control while the balance comprises
private sector and foreign banks. The public sector
commercial banks are divided into three categories.
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52.52
7.68
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0.14
0.36
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0.52
4.74
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State bank group (eight banks): This consists of
the State Bank of India (SBI) and Associate Banks
of SBI. The Reserve Bank of India (RBI) owns the
majority share of SBI and some Associate Banks of
1
SBI. SBI has 13 head offices governed each by a
board of directors under the supervision of a central
board. The boards of directors and their committees
hold monthly meetings while the executive committee of each central board meets every week.
Nationalized banks (19 banks): In 1969, the Government arranged the nationalization of 14 scheduled commercial banks in order to expand the branch
network, followed by six more in 1980. A merger
reduced the number from 20 to 19. Nationalized banks
are wholly owned by the Government, although some
of them have made public issues. In contrast to the
state bank group, nationalized banks are centrally governed, i.e., by their respective head offices. Thus, there
is only one board for each nationalized bank and meetings are less frequent (generally, once a month).
The state bank group and nationalized banks are
together referred to as the public sector banks
(PSBs). Tables 1 and 2 provide details of public issues and post-issue shareholdings of these PSBs.
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Table 2: Issue of Subordinated Debt Instruments
for Inclusion in Tier-2 Capital During the
Year Ended March 1998 (Rs billion)
Name of Bank
Amount Permitted
Amount Raised
Punjab & Sind Bank
1.0
1.0
Bank of India
7.0
nil
Syndicate Bank
0.8
0.6
Dena Bank
2.0
1.5
Source: Reserve Bank of India.
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GDR = global depository receipt.
a Reserve Bank of India/State Bank of India.
Source: Reserve Bank of India.
Total
State Bank of Travancore
Corporation Bank
Bank of India
Bank of Baroda
Dena Bank
Oriental Bank of Commerce
State Bank of Bikaner & Jaipur
State Bank of India (GDR)
State Bank of India
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January 1998
October 1997
February 1997
December 1996
October 1994
December 1996
November 1997
October 1996
December 1993
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Equity Before
Public Issue
Date of Issue
Name of Bank
Table 1:
Public Equities by Public Sector Banks, 1993–1998 (Rs billion)
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2.74
2.00
Equity
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0.75
0.15
0.35
2.66
0.38
0.82
5.25
1.50
4.89
7.50
1.00
1.96
3.00
1.20
0.65
0.60
1.28
1.47
0.60
12.18
19.38
Premium
Public Issue
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60.15
0.90
3.04
6.75
8.50
3.60
1.80
0.73
12.70
22.12
Total
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0.38
0.82
4.89
1.96
1.28
1.47
0.38
3.14
3.14
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0.12
0.38
1.50
1.00
0.65
0.60
0.13
2.12
1.60
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0.50
1.20
6.39
2.96
1.93
2.07
0.50
5.26
4.74
Total
Others
Governmenta
Equity After Public Issue
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76.00
68.33
77.00
66.88
66.48
71.00
75.00
59.73
66.34
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31.67
24.00
23.00
33.12
33.52
29.00
25.00
41.27
33.66
Others
Governmenta
Percent Share
?
THE INDIAN BANKING SECTOR: ON THE ROAD TO PROGRESS
Regional Rural Banks (RRBs): In 1975, the
state bank group and nationalized banks were required to sponsor and set up RRBs in partnership
with individual states to provide low-cost financing
and credit facilities to the rural masses.
Table 3 presents the relative scale of these public
sector commercial banks in terms of total assets.
The table clearly shows the importance of PSBs.
61
Total Assets
(Rs billion)
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Number
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2,043.56
3,519.05
444.54
161.13
559.11
190.51a
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8
19
25
9
39
196
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RBI is the banker to banks—whether commercial,
cooperative, or rural. The relationship is established
once the name of a bank is included in the Second
Schedule to the Reserve Bank of India Act, 1934.
Such bank, called a scheduled bank, is entitled to
facilities of refinance from RBI, subject to fulfillment
of the following conditions laid down in Section 42
(6) of the Act, as follows:
• it must have paid-up capital and reserves of an
aggregate value of not less than an amount specified from time to time; and
• it must satisfy RBI that its affairs are not being
conducted in a manner detrimental to the interests of its depositors.
The classification of commercial banks into scheduled and nonscheduled categories that was introduced
at the time of establishment of RBI in 1935 has been
extended during the last two or three decades to include state cooperative banks, primary urban coop-
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Reserve Bank of India and Banking
and Financial Institutions
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More than 40,000 NBFCs exist, 10,000 of which
had deposits totaling Rs1,539 billion as of March 1996.
After public frauds and failure of some NBFCs,
RBI’s supervisory power over these high-growth and
high-risk companies was vastly strengthened in January 1997. RBI has imposed compulsory registration
and maintenance of a specified percentage of liquid
reserves on all NBFCs.
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Source: Reserve Bank of India.
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aAs of March 1996.
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State Bank of India and associates
Nationalized banks
Old private sector banks
New private sector banks
Foreign banks
Regional rural banks
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Bank
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Table 3: Structure of the Banking Industry in
Terms of Total Assets, March 1997
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A STUDY OF FINANCIAL MARKETS
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62
erative banks, and RRBs. RBI is authorized to exclude the name of any bank from the Second Schedule if the bank, having been given suitable opportunity to increase the value of paid-up capital and improve deficiencies, goes into liquidation or ceases to
carry on banking activities.
A system of local area banks announced by the
Government in power until 1997 has not yet taken
root. RBI has given in principle clearance to five
applicants.
Specialized development financial institutions
(DFIs) were established to resolve market failures
in developing economies and shortage of long-term
investments. The first DFI to be established was the
Industrial Finance Corporation of India (IFCI) in 1948,
and was followed by SFCs at state level set up under a special statute. In 1955, Industrial Credit and
Investment Corporation of India (ICICI) was set up
in the private sector with foreign equity participation. This was followed in 1964 by Industrial Development Bank of India (IDBI) set up as a subsidiary
of RBI. The same year saw the founding of the first
mutual fund in the country, the Unit Trust of India
(UTI).
A wide variety of financial institutions (FIs) has
been established. Examples include the National
Bank for Agriculture and Rural Development
(NABARD), Export Import Bank of India (Exim
Bank), National Housing Bank (NHB), and Small
Industries Development Bank of India (SIDBI),
which serve as apex banks in their specified areas
of responsibility and concern. The three institutions
that dominate the term-lending market in providing
financial assistance to the corporate sector are
IDBI, IFCI, and ICICI. The Government owns insurance companies, including Life Insurance Corporation of India (LIC) and General Insurance Corporation (GIC). Subsidiaries of GIC also provide
substantial equity and loan assistance to the industrial sector, while UTI, though a mutual fund, conducts similar operations. RBI also set up in April
1988 the Discount and Finance House of India Ltd.
The magnitude and complexity of the Indian banking
sector can be understood better by looking at some
basic banking data. Table 4 shows classification of
banks based on working funds.
Table 4: Classification of Banks Based on Working
Funds, as of 31 March 1997
Classification
Working Funds (Rs billion)
Small
Up to 50
Medium
50–100
Large
100–250
Very Large
250–500
Exceptionally Large
Above 500
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Magnitude and Complexity
of the Banking Sector
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Source: Reserve Bank of India.
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(DFHI) in partnership with SBI and other banks to
deal with money market instruments and to provide
liquidity to money markets by creating a secondary
market for each instrument. Major shares of DFHI
are held by SBI.
Liberalization of economic policy since 1991 has
highlighted the urgent need to improve infrastructure in order to provide services of international standards. Infrastructure is woefully inadequate for the
efficient handling of the foreign trade sector, power
generation, communication, etc. For meeting specialized financing needs, the Infrastructure Development Finance Company Ltd. (IDFC) was set up
in 1997. To nurture growth of private capital flows,
IDFC will seek to unbundle and mitigate the risks
that investors face in infrastructure and to create
an efficient financial structure at institutional and
project levels. IDFC will work on commercial orientation, innovations in financial products, rationalizing the legal and regular framework, creation of a
long-term debt market, and best global practices on
governance and risk management in infrastructure
projects.
NBFCs undertake a wide spectrum of activities
ranging from hire purchase and leasing to pure investments. More than 10,000 reporting NBFCs (out
of more than 40,000 NBFCs operating) had deposits of Rs1,539 billion in 1995/96. RBI initially limited
their powers, aiming to moderate deposit mobilization in order to provide depositors with indirect protection. It regulated the NBFCs under the provisions of Chapter IIIB of the RBI Act of 1963, which
were confined solely to deposit acceptance activities of NBFCs and did not cover their functional
diversity and expanding intermediation. This rendered the regulatory framework inadequate to control NBFCs. The RBI Working Group on Financial
Companies recommended vesting RBI with more
powers for more effective regulation of NBFCs. A
system of registration was introduced in April 1993
for NBFCs with net owned funds (NOF) of
Rs5 million or above.
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THE INDIAN BANKING SECTOR: ON THE ROAD TO PROGRESS
In terms of growth, the number of commercial
bank branches rose eightfold from 8,262 in June 1969
(at the time of nationalization of 14 banks) to 64,239
in June 1998. The average population per bank
branch dropped from 64,000 in June 1969 to 15,000
in June 1997, although in many of the rural centers
(such as in hill districts of the North), this ratio was
only 6,000 people per branch. This was achieved
through the establishment of 46,675 branches in rural and semi-urban areas, accounting for 73.5 percent of the network of branches. As of March 1998,
deposits of the banking system stood at Rs6,013.48
billion and net bank credit at Rs3,218.13 billion.
The number of deposit accounts stood at 380 million and the number of borrowing accounts at 58.10
million. Tables 5, 6, and 7 reflect the diversification
of branch network attained by commercial banks,
the regional balance observed since nationalization,
and stagnation in branch expansion in the post-reform period. There has been a net decline in the number of rural branches and a marginal rise in the number of semi-urban branches.
The outreach of cooperative banks and RSBs is
shown in Table 8.
In an effort to increase the flow of funds through
cooperative banks, the resources of the main
63
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46.8
33.0
44.2
25.0
0.0
37.5
85.7
51.7
State Bank of India
Associate Banks of SBI
Nationalized banks
Indian private sector banks
Foreign banks in India
Nonscheduled banks
Regional rural banks
Total
?
?
?
?
?
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?
?
?
?
?
?
?
?
?
?
?
?
?
Sources: Indian Bank’s Association, Reserve Bank of India.
?
?
?
4,127
1,387
13,897
1,136
0
3
12,368
32,918
State Bank of India
Associate Banks of SBI
Nationalized banks
Indian private sector banks
Foreign banks in India
Nonscheduled banks
Regional rural banks
Total
?
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Number of branches
2,412
1,346
936
1,490
718
605
6,518
5,971
5,083
1,567
1,049
783
3
17
161
2
1
2
1,791
277
3
13,783
9,379
7,573
Percent distribution
27.3
15.3
10.6
35.5
17.1
14.4
20.6
19.0
16.2
34.6
23.1
17.3
1.7
9.4
88.9
25.0
12.5
25.0
12.4
1.9
0.0
21.7
14.7
11.9
?
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?
?
?
?
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
?
?
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?
?
?
?
?
?
46.6
32.6
43.7
24.3
0.0
33.3
85.4
51.2
4,120
1,389
13,914
1,145
0
3
12,311
32,882
8,821
4,200
31,469
4,535
181
8
14,439
63,653
Total
Metropolitan
Urban
As of 30 June 1997
Semi-urban
Rural
Bank Group
Bank Group and Population Groupwise Distribution of Commercial Bank Branches in India
Rural
?
?
?
Metropolitan
Urban
Number of branches
2,414
1,358
947
1,505
744
623
6,616
6,100
5,176
1,609
1,102
860
3
17
168
2
1
3
1,822
282
5
13,971
9,604
7,782
Percent distribution
27.3
15.4
10.7
35.3
17.5
14.6
20.8
19.2
16.3
34.1
23.4
18.2
1.6
9.0
89.4
22.3
11.1
33.3
12.6
2.0
0.0
21.7
15.0
12.1
Semi-urban
As of 30 June 1998
?
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?
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?
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
8,839
4,261
31,806
4,716
188
9
14,420
64,239
Total
?
?
A STUDY OF FINANCIAL MARKETS
Table 5:
64
refinancing agency, NABARD, were boosted substantially through deposits under the Rural Infrastructure Development Fund placed by commercial banks,
as well as through the improvement of NABARD’s
capital base and increase in the general line of credit
by RBI. The functioning of cooperative banking institutions did not show much improvement during
1996/97 and 1997/98. With deposits and credit indicating general deceleration, the overdue position of
these institutions remained more or less stagnant.
However, cooperative banks emulated the changing
structure and practices of the commercial banking
sector in revamping their internal systems, ensuring
in the process timely completion of audit and upgrading of their financial architecture. In various regions,
there is a differing pattern of cooperative banking,
determined according to the strength of the cooperative movement. Some cooperatives such as those
in the dairy and sugar sectors are as big as corporate
entities. In fact, dairy cooperatives compete with multinational corporations such as Nestlé.
There is also a category in the cooperative sector
called primary (urban) cooperative banks (PCBs).
As of March 1998, there are 1,416 reporting PCBs
catering primarily to the needs of lower- and middleincome groups. These are mainly commercial in character and located mostly in urban areas. Some have
become a competitive force with notably big branch
network and high growths recorded. As of 1998,
PCBs have deposits of Rs384.72 billion and advances
of Rs264.55 billion, as indicated in Table 9. Table 10
shows the gross NPA ratio of PCBs.
The advances of PCBs fall in the majority of categories of priority sectors prescribed for PSBs and
their recovery performance is better than that of
PSBs.
The cooperative banks also perform basic functions of banking but differ from commercial banks in
the following respects:
• commercial banks are joint-stock companies under the Companies Act of 1956, or public sector
banks under a separate Act of the Parliament.
?
THE INDIAN BANKING SECTOR: ON THE ROAD TO PROGRESS
?
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Table 6: Credit-Deposit Ratio and Investment-and-Credit-Deposit Ratio of Scheduled Commercial Banks,
By Region (percent)
Investment-and-Credit-Deposit Ratio
1996
Northern Region
48.6
60.8
1997
1998
1995
1996
51.0
54.5
53.4
66.5
35.6
34.5
Eastern Region
47.1
47.7
29.9
58.5
68.8
56.9
39.8
63.2
62.7
63.4
40.5
63.2
69.4
Southern Region
69.4
76.6
?
39.0
Western Region
35.1
55.1
57.3
55.7
65.5
68.0
67.2
73.9
72.3
80.5
80.9
87.1
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Central Region
?
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Northeastern Region
?
?
?
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1995
?
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Credit-Deposit Ratio
Region
?
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Sources: Indian Bank’s Association, Reserve Bank of India.
?
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Table 7: Distribution of Commercial Bank Branches, By Regiona
Average Population per Bank Branch (thousand)
1997
1,253
10,003
90
1,898
1998
1969
1997
1998
10,159
46
12
12
1,898
203
19
20
878
11,506
Central Region
1,090
13,143
11,567
135
18
18
13,225
115
18
18
9,951
38
14
14
17,430
44
13
13
9,828
2,996
17,267
?
1,955
Southern Region
?
?
Western Region
?
?
?
?
Eastern Region
?
Northeastern Region
?
?
Northern Region
?
?
1969
?
?
?
Number of Branches
Region
?
a Data are as of June 30 of each year.
?
?
?
?
Sources: Indian Bank’s Association, Reserve Bank of India.
?
?
?
Table 8: Outreach of Cooperative Banks and Regional Rural Banks, as of March 1997
SCBs
28
Number of Branches
?
Number of Banks
Deposits (Rs billion)
Loans and Advances (Rs billion)
1,764.92
289.46
288.12
299.57
167.64
85.00
11,791
196
14,513
?
364
RRBs
19
854
PCARDBs
738
745
1.63
21.51
. 0.59
14.52
?
?
?
?
SCARDBs
?
?
DCCBs
?
?
779
?
?
Name
?
Table 10:
Gross Nonperforming Asset Ratio of
Primary (Urban) Cooperative Banks
1996
1997
1998
Perioda
Number of
Reporting PCBs
NPA/Total
Advances (%)
38.48
46.95
56.59
241.65
307.14
384.72
7.58
6.19
8.39
179.08
215.50
264.55
1,327
1,363
1,416
?
?
Number of reporting banks
1995
1996
1997
1998
832
1,161
1,363
179
13.9
12.9
13.3
11.0
?
Loans outstanding
?
?
Borrowings
?
?
Deposits
?
Owned funds
?
?
Item
?
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Table 9: Primary (Urban) Cooperative Bank
Deposits and Other Funds (Rs billion)
?
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?
DCCB = district credit cooperative bank, PCARDB = primary cooperative agriculture and rural development bank, RRB = regional rural bank, SCB = scheduled commercial
bank, SCARDB = state cooperative and agricultural rural development bank.
Sources: Reserve Bank of India, National Bank for Agriculture and Rural Development.
?
Source: Reserve Bank of India.
NPA = nonperforming asset, PCB = primary (urban) cooperative bank.
a As of 31 March.
Source: Reserve Bank of India.
65
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Cooperative banks were established under the
Cooperative Societies Acts of different states;
• cooperative banks have a three-tier setup, with
state cooperative bank at the apex, central/district cooperative banks at district level, and primary cooperative societies at rural level;
• only some of the sections of the Banking Regulation Act of 1949 (fully applicable to commercial banks), are applicable to cooperative banks,
resulting in only partial control by RBI of cooperative banks; and
• cooperative banks function on the principle of
cooperation and not entirely on commercial parameters.
?
A STUDY OF FINANCIAL MARKETS
?
The Nonperforming Asset Problem
?
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Policy Issues in the
Banking Sector
?
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OPTIMISM WITH RESPECT TO THE
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Nonperforming Asset Level and Ratios
of Public Sector Banks
?
392.53
410.41
383.85
416.61
435.77
456.53
NPA/
Total Assets
(percent)
?
1993
1994
1995
1996
1997
1998
NPA/Gross
Advances
(percent)
?
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11.8
10.8
8.7
8.2
7.8
7.0
NPA = nonperforming assets.
Source: Reserve Bank of India.
?
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23.2
24.8
19.5
18.0
17.8
16.0
?
?
Year
Gross NPAs
(Rs billion)
?
?
Table 11:
?
?
The NPAs of public sector banks were recorded at
about Rs457 billion in 1998 (Table 11). By 1997/98
banks had managed to recover Rs250 billion and provisioned for Rs181.39 billion. But since new sets of
loans go bad every year, the absolute figures could
be increasing. About 70 percent of gross NPAs are
locked up in “hard-core” doubtful, and loss assets,
accumulated over years. Most of these are backed
by securities, and, therefore, recoverable. But these
are pending either in courts or with the Board for
Industrial and Financial Reconstruction (BIFR).
?
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?
NONPERFORMING ASSET PROBLEM
?
66
NPAs in Indian banks as a percentage of total
assets is quite low. The NPA problem of banking
institutions in India is exaggerated by deriving NPA
figures based on percentage against risk assets instead of total earning assets. The Indian banking system also makes full provisions and not net of
collaterals as practiced in other countries.
Narasimham Committee (II) noted the danger of
opaque balance sheets and inefficient auditing systems resulting in an underrating of NPAs. Nevertheless, there is a general feeling that the NPA problem
is manageable. Considerable attention is being devoted to this problem by RBI, individual banks, and
shareholders (Government and private).
With the increasing focus internationally on NPAs
during the 1990s affecting the risk-taking behavior of
banks, governments and central banks have typically
reacted to the problem differently depending on the
politico-economic system under which the banks operate. In some countries such as Japan, banks have
been encouraged to write off bad loans with retained
earnings or new capital or both. This ensures that the
cost of resolving the NPA problem is borne by the
banks themselves. However, this policy is not suitable
for countries such as India where the banks neither
have adequate reserves nor the ability to raise new
capital. In some countries, the banks are State owned
so the final responsibility of resolving the problem lies
with the respective national government. In these cases,
the governments concerned have been forced to
securitize the debt through debt underwriting and recapitalization of the banks. For instance, in Hungary,
guarantees were established for all or part of the bad
loans with the banking system, while in Poland, loans
have been consolidated with the help of long-term restructuring bonds.
Most of these countries have emphasized efforts
to recover the bad loans from the borrowers, usually
in conjunction with one or both the measures mentioned above. If direct sale of the assets of defaulting
firms was deemed nonviable, banks were encouraged
to coerce these firms to restructure. The former
?
THE INDIAN BANKING SECTOR: ON THE ROAD TO PROGRESS
?
Outstanding Advances to Priority Sectors by Public Sector Banks
?
Table 12:
Agriculture
Small-scale industries
Others a
Total
162.00
257.00
22.00
441.00
212.04
215.61
104.32
531.97
Agriculture
Small-scale industries
Others a
Total
5.4
8.5
0.7
14.6
15.0
15.3
7.4
37.8
March
1995
March
1996
March
1997
March
1998
Amount (Rs billion)
235.13
263.51
258.43
294.82
124.38
137.51
617.94
696.09
310.12
315.42
165.48
791.31
343.05
381.09
188.81
913.19
16.4
16.6
8.7
41.7
15.7
17.5
8.7
41.8
?
March
1994
Percent of Net Bank Credit
13.9
14.3
15.3
16.0
7.4
7.5
36.6
37.8
a Include small transport operations, self-employed persons, rural artisans, etc.
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June
1969
Type
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MAIN CAUSES OF NONPERFORMING ASSETS
One of the main causes of NPAs in the banking sector is the directed loans system under which commercial banks are required to supply a prescribed
percentage of their credit (40 percent) to priority
sectors. Table 12 shows that credit supply of PSBs
to the priority sectors has increased gradually to a
little more than 40 percent of total advances as of
March 1998. Loans to weaker sections of society
under state subsidy schemes have led borrowers to
expect that like a nonrefundable state subsidy, bank
loans need not be repaid.
Directed loans supplied to the “micro sector” are
problematic of recoveries especially when some of
its units become sick or weak. Table 13 shows PSB
loans to sick/weak industrial units. Nearly 7 percent
of PSB’s net advances was directed to these units.
Clearly, these units are one of the most significant
sources of NPAs, rather than bank mismanagement
on the scale that has been seen in Japan and some
Southeast Asian countries. The weakness of the
banking sector revealed by the accumulated NPAs
stems more from the fact that Indian banks have to
?
?
Czechoslovakia and Poland, for example, consolidated
all NPAs into one or more “hospital” banks, which
were then vested with the responsibility to recover
the bad loans. In Poland, this centralization of the recovery process was supplemented by regulations that
authorized the loan recovery agency to force the defaulting industrial units to either restructure or face
liquidation. Other countries such as Bulgaria created
“hospital” banks and legalized swap of debt for equity
that gave banks stakes in the defaulting firms, and
hence provided them with the incentive and the power
to restructure the enterprises.
In India, conversion of loans into equity is an option that should be seriously considered instead of
attempting recovery solely through either or both legal means and an asset reconstruction company
(ARC). Unlike NPAs, the substitute asset of equity
will be an intangible investment ready for sale to potential buyers. The DFIs have a formal conversion
clause for debt to be exchanged for equity that ought
to be exercised not only if it is an NPA but also if the
equity is appreciating. This clause has not been so
far much exercised.
?
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?
?
Source: Reserve Bank of India, Report on Trend and Progress of Banking in India 1997/98, July 1997–June 1998.
?
Public Sector Banks’ Loans to Sick/Weak Industrial Units (Rs billion)
?
Table 13:
?
Non-SSI Sick Units
Non-SSI Weak Units
Total
1997
6.36
29.44
1.42
37.22
4.79
30.32
0.98
36.09
1996
1997
33.66
26.24
28.33
88.23
31.07
25.27
29.60
86.14
1996
1997
1996
1997
?
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?
?
?
Potentially viable units
Nonviable units
Viability not decided
Total
?
?
1996
?
?
SSI Sick Units
Item
?
SSI = small-scale industry.
Source: Reserve Bank of India, Report on Trend and Progress of Banking in India 1997/98, November 1997.
5.12 5.57
3.31 2.96
3.61
7.11
12.04 15.64
45.14
41.43
58.99
58.55
33.36
37.89
137.49 137.87
67
SMALL-SCALE INDUSTRIES: DECLINE IN SICK
?
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Operational restructuring of banks should ensure
that NPAs in the priority sectors are reduced, but
not priority sector lending. This will remain a priority
for the survival of banks. Any decisions about insulating Indian banks from priority sector financing
should not be reached until full-scale research is undertaken, taking into account several sources including records of credit guarantee schemes.
UNITS AND NONPERFORMING ASSETS
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serve social functions of supporting economically
weak sectors with loans at subsidized rates.
The Narasimham Report (II) recommended that
the directed credit component should be reduced from
40 to 10 percent. As the directed credit component
of the priority sectors arises from loan schemes requiring Government approval of beneficiaries, banks’
selection standards with regard to eligible borrowers
are being interfered with. The nexus of subsidies
should be eliminated from bank loan schemes. Targets or prescribed percentages of credit allocation
toward the priority sectors should not be confused
with directed credit.
Government subsidy schemes were intended originally to prompt bankers to lend to weaker sectors.
But as the directed credit component became partly
politicized and bureaucratized, the realization has
grown that priority sector bank credit should operate
with the required degree of risk management.
However, the dangers of the priority credit system
to sound banking should not be exaggerated. The
shackles of “directed lending” have been removed and
replaced by tests of commercial viability. Economic
activities classified under priority sector have undergone a metamorphosis and upgrade since 1969 when
banks were first nationalized and assigned the role of
financing the sector. The expansion of the definition
of the priority sector, upgrade in the value limit to determine small-scale industry (SSI) status, and provision for indirect lending through placement of funds
with NABARD and SIDBI have lightened the performance load of banks. Thus, priority sector financing is no longer a drag on banks. But in the long term,
Indian banks should be freed from subsidized lending.
The scope in India for branch expansion in rural
and semi-urban areas is vast and also necessary.
Increasingly, NBFCs operating at such places are
coming under regulatory pressure and are likely to
abandon their intermediation role. Banks will have to
move in to fill the void and these branches will find
priority sector financing as the main business available especially in rural/semi-urban centers.
?
A STUDY OF FINANCIAL MARKETS
?
68
In 1996-1997, banks conducted a viability study
across the country of 229,234 SSI units and identified 16,220 units as being potentially viable. In its
report on Currency and Finance, RBI said that the
number of sick units fell from 262,376 in March 1996
to 235,032 in March 1997. Of the viable units, 10,539
units had outstanding credit of Rs32.22 billion under
a nursing program for turnaround or rehabilitation.
The RBI has called for half-yearly reports from banks
to monitor progress in industrial rehabilitation. In addition, it has also issued guidelines to banks on the
need for proper coordination between them and termlending institutions in the formulation and implementation of a rehabilitation program.
The main causes of industrial sickness in non-SSI
units were internal factors such as deficiencies in
project management (44.8 percent of the cases) and
shortcomings in project appraisals (7.2 percent), as
well as external factors such as nonavailability of
raw materials, power shortages, transport and financial bottlenecks, increases in overheads, changes in
Government policy, and demand shortfalls. The report notes that the number of sick/weak units, both
SSIs and non-SSIs, decreased by 27,350 (10.3 percent) from 264,750 in March 1996 to 237,400 at endMarch 1997. However, the amount of outstanding
bank credit in this regard increased by Rs3.88 billion
(3 percent) during 1996/97 to Rs137.87 billion.
The SSI sector accounted for about 99 percent of
the total sick units, but the share in total bank credit
outstanding to such units was only 26.2 percent. The
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INCOME RECOGNITION
RBI guidelines stipulate that interest on all NPAs
should not be charged and considered in the income
account. The guidelines create some complications
in the accounting system. For instance, if a loan has
turned into an NPA shortly before the end of a financial year, the interest payments during the current and previous financial years are considered not
yet earned and the corresponding book entries recognizing interest income should be reversed. The
definition of income recognition has become a critical issue in presenting a clear picture on the profit/
loss account of banks. A review and, if necessary,
change in the guidelines and accounting system should
immediately be undertaken.
?
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?
number of non-SSI sick units declined marginally from
2,374 in March 1996 to 2,368 in March 1997. Outstanding bank credit to these units also showed a
decline of 2.4 percent from Rs88.23 billion at endMarch 1996 to Rs86.14 billion in March 1997. The
priority sector to which SSI belongs is not such a
burden on banks. On the contrary, it offers a good
spread of risks and business opportunities for all types
of branches—metro, urban, semi-urban, and rural.
On the other hand, in the case of non-SSI industrial
units, banks are not the only source of institutional
finance, a major part of which comes from AIFIs at
the project formulation stage. There will be a need
to separately study NPAs in which banks and AIFIs
have common exposure.
?
THE INDIAN BANKING SECTOR: ON THE ROAD TO PROGRESS
CORPORATE ACCOUNTS—TRANSPARENCY
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One of the important amendments introduced by the
2
Companies (Amendment) Ordinance in 1998 requires that companies comply with accounting standards. As a step towards good corporate governance
and better disclosure and presentation of accounts, it
is a milestone. However, it was introduced and implemented in a halfhearted way. While the auditor was
required to check on compliance with accounting
standards, there was no statutory requirement for
the company to make such compliance. Now the
ordinance says that companies shall comply with
accounting standards as defined.
The requirement covers all companies, public
or private, listed or unlisted. That accounting standards are now compulsory is contradicted by the
requirement that if the accounting standards are
not complied with, the fact of such noncompliance,
and the reasons and the financial effect of such
Banks’ Recapitalization Needs in Asia
?
Table 14:
?
?
?
NPA figures may be high in Indian banks, but certain factors need to be noted before comparing the
country’s system with that of other Asian nations.
For instance, only 48 percent of banking institutions’
assets are in corporate loans. The high level of preemption of bank funds by the Government in the form
of cash reserve requirement (CRR) and statutory
liquidity requirement (SLR) is one of the reasons for
low profitability of banks and poor returns on assets.
However, in times of stress, such as the recent economic crisis, these same assets provide balance sheet
strength. India’s contrast with the crisis-affected
countries is clear from Table 14. Bank recapitalization needs in India are the lowest as a percentage of
gross domestic product (GDP) while their contribution to developmental banking is high. This emphasizes the need for the Government to back the PSBs
even in the weak category.
?
?
?
COMPARISON WITH ASIAN COUNTRIES
?
Recapitalization Needs
($ billion)
?
GDP 1997
($ billion)
Recapitalization/GDP
(percent)
Loans/Assets
(percent)
1.7
12.2
14.3
9.5
31.4
42
70
52
69
78
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381
205
442
95
153
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India
Indonesia
Korea
Malaysia
Thailand
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Country
GDP = gross domestic product.
6.5
25.0
63.0
9.0
48.0
69
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tors’ role in this direction are likely to outweigh costs.
Auditors are also required under the new statement
to add a paragraph in their audit report that highlights
the going concern problem by drawing attention to
the relevant note in the financial statement. They
must qualify their report, however, if the management does not make adequate disclosure in the financial statements.
Clients are unlikely to welcome the going concern
qualification and their apprehension may well be reinforced if it restricts their freedom of action, by forcing covenants in loan agreements to be activated or
by restricting the freedom to pay dividends. Moreover, because of the lack of any form of quantification, qualified reports are likely to be fuzzy and may
differ significantly depending on the interpretation of
each audit firm. Following well-settled international
practice, it should be made mandatory for directors
to confirm that the financial statements have been
prepared on the basis of the going concern assumption. Auditors should then examine appropriate financial and other information and, if they are not
satisfied, comment appropriately in their audit report.
PROBLEM OF THE REAL SECTOR VS.
BANKING SECTOR REFORMS
Changes in M3 and its select components—net bank
credit to Government (NBCG) and net bank credit
to commercial sector (NBCCS)—show that credit
offtake has slowed down and even declined in
1998/99 for NBCCS (see Tables 15 and 16). Government funding from banks has been rising in the
last three years. An increase in new bank credit to
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?
noncompliance shall be disclosed. It is possible that
a company can get away with noncompliance
merely by making the required disclosures.
The “going concern” is a fundamental accounting
concept that allows financial statements to be prepared on the assumption that the enterprises will continue in operational existence in the foreseeable future. The Institute of Chartered Accounts of India in
1998 issued a Statement on Standard Auditing Practices (SAP 16) that aims to establish auditors’ responsibilities regarding the appropriateness of the
going concern assumption as a basis for preparing
financial statements. It also elaborates the need for
planning and conducting audits, gathering sufficient
evidence, and exercising judgment whether the going concern assumption made by directors is appropriate. The practice was to be followed for accounting periods commencing on or after April 1999. The
conclusion that a financial statement has been prepared for a going concern depends on a few fundamental uncertainties.
Prominent among these is availability of future
funding, which may affect future results as well as
investments needed and changes in capital structure.
In addition, auditors will have to look at cash generated from operations and other cash inflows, capital
funding and Treasury policies, inherent strengths and
resources of the business, and availability of liquidity
at the end of the period. All these extend the scope
of the audit. Even if one accepts that auditors are
capable of providing information about business risks
that is useful to investors and other parties, it is questionable whether the benefits of expanding the audi-
?
A STUDY OF FINANCIAL MARKETS
?
Annual Changes in M3, 1990/91–1997/98 (Rs billion)
?
Table 15:
?
NBCG
?
?
?
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1,401.93
1,762.38
2,039.18
2,224.19
2,557.78
2,886.20
3,306.19
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na
1,009.97
675.82
970.19
725.81
978.41
1,235.41
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Variation
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M3
2,658.28
3,668.25
4,344.07
5,314.26
6,040.07
7,018.48
8,253.89
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1990/91
1992/93
1993/94
1994/95
1995/96
1996/97
1997/98
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Year
?
?
na = not available.
NBCG = net bank credit to Government, NBCCS = net bank credit to commercial sector.
Source: Reserve Bank of India.
?
70
Variation in NBCG
NBCCS
Variation in NBCCS
na
360.45
276.80
185.01
333.59
328.42
419.99
1,717.96
2,201.35
2,337.74
2,927.23
3,446.48
3,763.07
4,321.90
na
483.39
136.39
589.49
519.25
316.59
558.83
?
THE INDIAN BANKING SECTOR: ON THE ROAD TO PROGRESS
?
Monthly Changes in M3, March–July 1998/99 (Rs billion)
?
Table 16:
M3
Variation
NBCG
Variation in NBCG
NBCCS
Variation in NBCCS
March
April
May
June
July
8,253.89
8,376.64
8,460.14
8,554.03
8,616.23
na
122.75
83.50
93.89
62.20
3,306.19
3,360.85
3,497.40
3,601.38
3,666.97
na
64.76
136.55
203.98
65.59
4,321.90
4,316.36
4,298.30
4,286.27
4,329.23
na
(5.54)
(18.06)
(12.03)
42.96
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three problems are interrelated and suggest the need
for short- and long-term measures.
The basic maladies affecting the financial sector
in India are as follows:
• structural weakness of the real sector and lack
of competitiveness in international markets, and
• underdeveloped credit delivery systems that fail
to respond to fast changing situations.
Strengthening the viability of the real sector has
much relevance to the future strength of the Indian
financial system. The Committee on Capital Account
Convertibility has not dwelt on the impact of expected
inflows of capital in relation to efficiency and absorptive capacity of the real sector on the one hand,
while emphasizing the needed strength of the financial sector on the other.
It is mainly the second malady that has to be overcome by banks and financial institutions. Future reforms will have to focus on how the real and the
banking sectors can strengthen each other.
INDIAN CORPORATE SECTOR
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the commercial sector in 1997/98 is partly due
to liquidation of high cost external commercial borrowings. The real differences are more evident in
1998/99 (Table 16).
There is a close connection between the relatively
small flow of finance to enterprises, the downward
trend in the real sector, and the depressed stock
market. The economy’s downward trend has persisted despite several initiatives taken by the monetary authorities.
There has been a large-scale extension of bank
credit to the Government at the expense of the commercial sectors. This suggests that the principal reason for the poor growth of bank loans is “inadequate”
demand, which can be traced to developments in the
real sector. The troubles faced by the real sector
also seem to originate from a fall in market demand
for goods. In many industries, output expansion has
been nil to modest, often with inventory pileups. Adverse market conditions facing consumer goods industries strongly support the hypothesis concerning
demand failure in the real sector.
A cut in the bank rate by itself will have a limited
impact on the economy for the following reasons. First,
even if producers expect to make profits on their investment and banks are willing to lend, investment
may not materialize because of the difficulty of securing complementary finance from a depressed stock
market. Second, banks may be too wary of lending or,
more likely, may not have developed an efficient credit
delivery system to the major part of the economy. Third,
and most important, the large majority of producers
would take a dim view of future profitability of investment in the context of infrastructural bottlenecks. The
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na = not available, ( ) = negative values are enclosed in parentheses.
NBCG = net bank credit to Government, NBCCS = net bank credit to commercial sector.
Source: Reserve Bank of India.
The private sector’s (gross) investment in plant and
machinery rose from Rs120 billion per year (3 percent of GDP) in 1986-1990 to Rs730 billion per year
(7 percent of GDP) in 1995-1997. A sixfold increase
in investment in such a short span is a structural
change brought about by strong macroeconomic fundamentals and corporate management. There were,
however, deficiencies in the management of structural reforms.
The sequencing of the 1991 reforms seemed inappropriate. Securing quick gains in the form of foreign
institutional investor (FII) inflows into the capital
71
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CORPORATE SECTOR CONTROL OF
NONPERFORMING ASSETS
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market (instead of foreign direct investment [FDI])
failed to improve the real sector and fueled stock
price rises (the Government also did not take advantage of disinvestment in public sector holdings). Capital market liberalization and opening up avenues of
foreign funds raised through global depository receipt
(GDR) issues, and other sources were not matched
by a full upgrade and modernization of the industries
to increase their competitiveness.
A persistent trade deficit is indicative of an incorrect sequencing of reforms (in contrast with the
People’s Republic of China [PRC], which from 1990
onwards boosted foreign reserves through trade surpluses from manufactured goods exports). Not many
Indian listed companies have foreign trading exposure in the form of exports or imports. The concern
for Indian banks and FIs naturally is the risk of
underperformance of the real sector and lack of adequate cushion. Many companies have faced difficulties in coping with adverse foreign exchange fluctuation because of declines in the value of the rupee.
NPAs of banks with respect to corporate sector
lending have been caused by the following:
• mindless diversification;
• neglect of core competencies;
• diversion of new equity raised into nontradable
assets;
• inattention to cost controls;
• lack of coordination between banks and FIs; and
• rapid growth after liberalization of merchant
banks, which hastily vetted projects and initial
public offerings (IPOs) in the rush to beat competition, neglected to develop a debt market,
and gave extraordinary support to raising of
equity issues by the companies.
The depressed stock market has caused companies to turn back to banks for finance. The loss of
investor confidence happened even after several
reforms in the capital markets (some under the
United States Agency for International Development’s [USAID’s] Financial Institutions Reform Expansion [FIRE]) program.
?
A STUDY OF FINANCIAL MARKETS
?
72
Banks, FIs, and the market by themselves cannot
exercise control over companies. The reaction of investors to falls in bond and stock prices ensures that
any damage is limited once there is a perception that
something is wrong. Bank financing provides a shield
to companies from such short-term market whims if
the bank is satisfied the unit will pull through. In India, the process of disintermediation is of recent origin and DFIs have, in fact, a lot of hold on companies through their equity stakes and loan stakes in
the units financed. Even as the role of the stock market expands, banks and DFIs still have a significant
role as finance providers and some complementarity
of controls (in terms of rigors of financial discipline)
can be evolved to ensure corporate efficiency.
Banks are highly deficient on the stock market
side (a position well established by the dismal record
of mutual funds and merchant banking subsidiaries
floated by most of the public sector banks). Their
portfolios of investments in bonds and equities (which
are 100 percent risk assets) need to be screened
using credit risk assessment standards and not by
market prices alone. Banks also must adopt methods of converting debt into equities in NPA accounts
whenever possible to either ensure turnaround in
corporate performance, or else sell equities to limit
future losses. Currently, they do not have an exit
route. The case for corporate control is presented in
Table 17, which highlights the extent of cost consciousness in the corporate sector.
Despite competition and falling profits, there has
been no significant improvement in cost structure.
Also, the slowdown has not made cost consciousness a top concern. This is exactly what banks and
FIs have to be worried about. Equity holders, banks,
and FIs can position themselves as drivers of shareholder value. Credit risk analysis needs to be complemented by cost structure analysis and output efficiency with reference to the companies’ capital and
stock of borrowed funds. This is one reason why
?
Cost Curve—Composition and Structure
(as percent of sales)
1989/90 1993/94 1994/95 1997/98
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16.1
5.2
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17.2
4.5
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15.7
5.2
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14.0
4.9
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49.4
37.4
3.2
1.1
7.7
7.2
5.9
2.5
11.6
1.5
5.8
1.1
1.6
2.9
0.1
3.9
0.3
0.4
0.3
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49.0
37.0
3.1
1.2
7.7
7.1
5.8
2.7
12.9
1.5
5.1
0.9
1.5
2.6
0.1
3.6
0.2
0.2
0.3
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48.5
36.2
3.4
1.2
7.7
7.5
6.1
2.6
12.5
1.6
5.1
0.8
1.6
2.6
0.1
3.6
0.3
0.4
0.2
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49.2
38.3
3.6
0.5
6.9
8.5
5.9
2.3
13.5
1.7
4.6
0.6
1.4
2.5
0.0
3.8
0.5
0.3
0.0
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Raw materials, stores
Raw materials
Stores and spares
Packaging expenses
Purchase of finished goods
Wages and salaries
Energy (power and fuel)
Other manufacturing expenses
Direct taxes
Repair and maintenance
Selling and distribution expenses
Advertising
Marketing
Distribution
Amortization
Miscellaneous expenses
Nonrecurring expenses
Less: Expenses capitalized
Interest capitalized
Profit before depreciation,
interest, and tax
Interest
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Item
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Table 17:
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THE INDIAN BANKING SECTOR: ON THE ROAD TO PROGRESS
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DEBT RECOVERY TRIBUNAL REVAMP
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banks and FIs should maintain credit files on equity
or other tradable instruments of each issuer. In the
US, the Federal Reserve and Federal Deposit Insurance Corporation (FDIC) guidelines emphasize this
type of credit control. While analyzing credit offtake
volumes, RBI equates such portfolio holdings of banks
to loans and advances. Qualitatively, the risk-control
mechanism for the two categories of assets has to
be on absolute par level.
Table 17 also reflects how interest from borrowing from banks and FIs remains high among total
business costs of borrowers, while banks and FIs
have high liquidity. This problem can be combated
by macroeconomic intervention to reduce interest
rates to enable the economy to expand and the banks
to outgrow their problems, and by banks and FIs ensuring efficient use of capital by borrowers to improve allocative efficiency of resources.
The culture of just in time (JIT) inventories and
quick response (QR) to maintain an efficient supply
chain is still not evident in Indian business management. The credit delivery system is anchored around
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Source: National Council for Applied Economic Research.
requirements of average/peak inventory holdings and
outstanding receivables, although the earlier RBI
stipulations of industry-wise norms have been abolished. Banks are now free to decide but buildup of
current assets in borrowing units pushes up interest
costs of borrowing for existing borrowers and results in nonavailability of resources to new borrowers. Surplus liquidity in banks today is not an indicator of efficient allocation of credit resources.
Other issues concerning corporate control emerge
from closer analysis of how cash credits extended
by banks became NPAs of defaulting borrowers while
they floated new industries with the help of DFIs, as
well as how BIFR cases have dragged on. There
are 60 public sector units under BIFR review. Banks
and FIs need to study how favored projects of the
past became sick units later. Lack of transparency
in the accounts of corporates helped them to disguise cash flow projections for sourcing credit from
banks and FIs.
The final report of the working committee on Debt
3
Recovery Tribunals (DRTs) has recommended the
revamp of the tribunals to ensure that they are not
burdened with more than a specified number of cases.
It has also called for the exclusion of cases under
the Sick Industrial Companies Act (SICA) if these
cases are filed with DRTs. In short, this will mean
that DRTs could be given powers to override those
of BIFR, and this is the greatest stumbling block to
the recovery of bad debts.
According to the working group, not only should
there be a tribunal in every state but there should
also be more than one DRT in the same state if it is
justified by the workload of the tribunals. The DRTs’
prosecuting officers should not face more than 30
cases on any given date and there should not be more
than 800 cases in the pipeline at any given point. If
the number of cases exceeds 800, the Government
should consider appointing more tribunals to deal with
4
such cases. While the working committee has
73
ALL-INDIA FINANCIAL INSTITUTIONS
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NONPERFORMING ASSETS OF
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The net NPAs-total loans ratio at IDBI stood at
10.1 percent, ICICI at 7.7 percent, and IFCI at
13.6 percent as of 31 March 1998. However, loans
from other AIFIs such as LIC, GIC, UTI, and their subsidiaries, Risk Capital and Technology Corporation
(RCTC), Technology Development and Information
Company of India (TDICI), and Tourism Finance
Corporation of India (TFCI), to the industrial sector
have been substantial, but the data on their NPAs are
not readily available. For state-level institutions such
as SFCs and SIDCs, which lend to medium-size industry and SSI sectors, the NPA data are also not readily
available. State-level institutions benefit from a special recovery procedure allowed under their separate
enactment. With the exception of IDBI, ICICI, and
IFCI, the other AIFIs are not under RBI’s regulatory
discipline. There is a need to study features of their
loan operations, credit control, and NPAs.
Disclosure, Accounting Framework,
and Supervision
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Government ownership in banks attracts parliamentary review. The Estimates Committee of Parliament
takes a serious view of adverse comments made
against top managements of PSBs and NPAs on
account of transgression of powers. The committee
called for a total revamp of the training system for
bank officers. The committee also noted that public
sector undertaking (PSU) banks have to be able to
contain NPAs at a par with international standards
where the tolerable levels of NPAs are “around 3 to
4 percent.”
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PARLIAMENTARY REVIEW
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PUBLIC SECTOR BANKS’ BAD DEBTS:
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A total of 320 cases were registered with BIFR in
1998. This exceeded the 230 cases registered in
1997 and was a far cry from the 97 cases recorded
in 1996. According to Board officials, a more than
threefold rise in the number of cases registered
since 1996 could be due to the competition that
companies are facing because of economic liberalization.
On the other hand, the board seems to be unable
to cope with the deluge of cases. It is working with
only one bench and eight members. SICA provides
that the board shall consist of a chairman and a
minimum of two and maximum of 14 members.
From January to November 1998, the board disposed only 127 cases compared to 220 cases in
1997. With the disposal of another five to ten cases
in 1998, this adds up to a dismal record of about
135 cases—only almost half of the number of cases
disposed in 1997.
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RECONSTRUCTION
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FOR INDUSTRIAL AND FINANCIAL
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INADEQUACIES OF THE BOARD
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suggested that more recovery officers should be appointed to ensure speedy recovery of bank dues, it
has also stated that recovery officers may be given
the assistance of police and professional debt recovery agencies.
?
A STUDY OF FINANCIAL MARKETS
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74
Greater transparency in banks’ balance sheets and
penal action by RBI, including against bank auditors,
require highly focused action. Internal audits in banks,
now supervised by audit committees of respective
boards, have been more a formality than reflecting
management’s reporting responsibility to the stockholders of the banks. High standards of preventive
and detective (internal) controls are required. Risk
management with respect to “off-balance sheet
items” requires considerable attention as evidenced
by instances of losses on letters of credits and guarantees business. This applies also to auditing off-balance sheet items. At the macro level, the size of
NPAs as a percentage of GDP provides a good
measure to assess the soundness of the system.
The issue needs to be tackled in terms of market
segments from which NPAs have emerged: not putting them simply under the umbrella of “priority sector,” or “nonpriority sector” but individually, in much
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restructured troubled loan would not automatically
be classified as an impaired loan. In India, however,
any restructuring automatically classifies the assets
as impaired. Banks and institutions are required to
classify the restructured loans as substandard for two
years and are prohibited from booking interest during this period. The “relaxation” in asset classification norms will mean little in the Indian context.
In developed financial systems, it is beneficial to
have flexibility in determining weights for NPAs.
However, liberal measures should be introduced only
when all local players employ greater transparency
in the asset classification process. It is necessary to
first ensure that companies and borrowers follow
norms of disclosure and transparency. Much needs
to be done in this respect by the Institute of Chartered Accountants of India.
The condition of Indian banks under the present
norms has improved, contributing to a better culture
of recovery. The borrowers must respond with better performance.
SEPARATING SUPERVISION
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RBI is considering changes in asset classification,
income recognition, and provisioning norms in line
with recommendations of the Basle Committee on
Banking Supervision that were made public in October 1998. It remains to be seen if RBI will give banks
and FIs discretion in the classifications of assets,
partially replacing the prevailing rigid norms and redefining provisioning norms taking into account collateral. According to current practice, banks and FIs
are required to make 10 percent provisioning on substandard assets and 20 percent on doubtful assets,
even if the assets are backed by collateral.
The Basle Committee on Banking Supervision circulated a consultative paper entitled “Sound Practices for Loan Accounting, Credit Risk Disclosure,
and Related Matters,” complementing the Basle core
principles in the fields of accounting, and disclosure
for banks’ lending business and related credit risk.
RBI has already taken steps to implement the Basle
core principles, which broadly deal with risk management, prudential regulations relating to capital adequacy,
and various internal control requirements.
Banks and FIs have been insisting that existing
asset classification rules are rigid leaving no scope
for discretion, while the Basle Committee has said
that recognition and measurement of impairment of
a loan cannot be based only on specific rules. The
committee has also indicated that banks should identify and recognize impairment in a loan when the
chances of recovery are dim. It also stated that the
focus of assessment of each loan asset should be
based on the ability of the borrower to repay the
loan. The value of any underlying collateral factors
also plays a major role in this assessment.
Another major difference between the Basle Committee recommendations and the existing asset classification norms in India relates to “restructured”
loans. According to the Basle Committee norms, a
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PRUDENTIAL NORMS
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wider market segments (for example, agriculture as
a market segment has itself many subsegments).
?
THE INDIAN BANKING SECTOR: ON THE ROAD TO PROGRESS
The Narasimham Committee (II), while recommending separation of supervision, admits that conflicting
international experience has left no overwhelming
case for either separation or combining of the central bank’s supervisory powers. The likely conflict
between monetary policy and supervisory concerns
justifies the need to combine the two functions. Separate authority structures for the two functions have
more likelihood of coming into conflict with each other.
Economic downturns tend to highlight supervisory
concerns, and can put the banking system at risk and
subject the monetary authority to face the counterpressure of reflecting economic circumstances. The
choice then becomes one of fine balance. Combining
supervisory functions with monetary policy can provide a synergy that will get lost by separation. In fact,
central banks take on the supervisory function in more
than 60 percent of IMF member countries. In the case
of African and Asian countries alone, the figure is
75
Regulatory Issues
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reforms were first introduced under recommendation of the Narasimham committee (I), the 27 (then
28) PSBs were placed under A, B, and C categories; i.e., sound banks, banks with potential weakness, and sick banks, respectively. Accordingly, recapitalization and restructuring were carried out for
B and C categories.
For individual ratings by international rating agencies, a bank is assessed as if it were entirely independent and could not rely on external support. The
ratings are designed to assess a bank’s exposure to
risks, appetite for risks, and management of risks.
Any adverse or inferior rating is an indication that it
may run into difficulties such that it would require
support. Such credit rating announcements ignore the
public sensitivity to which the banking system is constantly exposed. The individual and support ratings
are further explained in Table 18.
The public expects banks to try to anticipate
changes, recognize opportunities, deal with and
manage risks to limit losses, and create wealth
through lending. While the best banks may always
play a super-safe role by confining operations to
choice centers and business segments, banks in
India are expected to operate on a high-risk plane.
As such, the Government should support banks
even during stages when they are nudged to offer
equity to the public.
INDIAN BANKS’ ASSOCIATION
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RBI has subjected banks to ratings under capital
adequacy, asset quality, compliance, and system
(CACS); and capital adequacy, asset quality, management, earnings, liquidity, and systems (CAMELS)
models for differentiating supervisory priorities. When
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RATING OF BANKS
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more than 80 percent. In other countries, supervision
involves varying degrees of central bank involvement.
The regulatory and supervisory systems have to
take into account peculiarities of the banking and financial structures as well as historical and cultural
factors. For example, in India, the rural banking sector is large and the cooperative movement strong but
the banks in this sector have remained generally financially weak. No amount of sophisticated monetary policy management is likely to provide props to
this sector. What it needs is financial strengthening,
management upgrades, and different norms of financial supervision with reference to culture and the economic activity of the clients. Rural and semi-urban
populaces need dependable banks and rarely get alternatives in the form of banking competition.
The importance of rural banking sector has been
overlooked in the various deliberations of banking and
financial reforms in India. Several issues need to be
raised in this regard. For instance, the separation of
supervisory functions and monetary policy formulation would only harm the interests of the rural banking
sector, which RBI and NABARD look after. Then,
there is also the question of the large number of urban
cooperative banks, which serve communities in different cities and adjoining areas. How can a separate
supervisory body develop methods and resources to
supervise these banks? Separation of the functions
may not necessarily strengthen either supervision or
monetary policy management, or both.
As NBFCs come increasing under the regulatory
gaze, there will be vacuum in places where there is
no bank and the NBFC is required to fold. Regulators have to ensure that banking expansion is promoted in these places.
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A STUDY OF FINANCIAL MARKETS
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76
The Indian Banks’ Association (IBA) should evolve
into a self-regulatory organization (SRO) that would
work toward strengthening India’s fairly weak banking sector and the sector’s moral regulator. Its broad
agenda should be to encourage the continued implementation of prudential business practices. IBA is
completing an organizational restructuring after which
it will examine its role as an SRO. It is now an advisory organization of banks in India and its members
include most of the PSBs, private banks, and foreign
banks. Its main activities involve generation and ex-
Ratings of Banks
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Table 18:
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THE INDIAN BANKING SECTOR: ON THE ROAD TO PROGRESS
Support Rating
Very Strong. Characteristics may include
outstanding profitability and balance sheet integrity,
franchise, management, operating environment, or
prospects.
A bank for which there is a clear legal guarantee on the part of
the state, or a bank of such importance both internationally and
domestically that support from the state would be forthcoming,
if necessary. The state in question must clearly be prepared
and able to support its principal banks.
Strong. Characteristics may include strong
profitablity and balance sheet integrity, franchise,
management, operating environment or prospects.
A bank for which state support would be forthcoming, even in
the absence of a legal guarantee. This could be, for example,
because of the bank’s importance to the economy or its historic
relationship with the authorities.
Adequate. Possesses one or more troublesome
aspects on profitability and balance sheet integrity,
franchise, and management, operating environment
or prospects.
A bank or bank holding company that has institutional owners of
sufficient reputation and possessing such resources that
support would be forthcoming, if necessary.
Weak. Weaknesses of internal and/or external
origin. There are concerns regarding profitability
and balance sheet integrity, franchise,
management, operating environment or prospects.
A bank for which support is likely but not certain.
Problematic. Has serious problems that either
require or are likely to require external support.
A bank or bank holding company, for which support, although
possible, cannot be relied upon.
IMPROVING REGULATORY FRAMEWORKS TO
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practices. This can, however, be all very well in theory
but difficult to practice because an SRO is more of a
culture than an institution. It takes a long time to breed
a culture of self-regulation. The respect for a supervisor has to be earned and does not happen overnight.
IBA has to transform itself into a “real” industry
body once the IBA management committee acts on
the blueprint for change proposed by a consulting
firm. The proposal is to overhaul the structure of the
organization to increase efficiency. The new focus
is on networking as IBA was, for a long time, working in isolation. Now the objective is to emerge as a
representative body for the banking industry. IBA has
already started interacting with different industries and
looking into various aspects of financing software companies, the film industry, construction companies, and
the shipping industry.
DECREASE SYSTEMIC RISK
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change of ideas on banking issues, policies; and practices; collection and analysis of sectoral data; personnel administration; and wage negotiations between
labor unions and bank managements. But in its new
role, it would reportedly expand its functions to supplement RBI’s role as a legal regulator with a focus on
strengthening the sector.
While the sector’s risk profile improved considerably after prudential norms were introduced in 1994,
by international standards, India’s banking sector is
perceived as fairly weak with poor asset quality by
leading agencies such as Standard & Poor’s. The
SRO would examine and recommend the implementation of more stringent prudential norms as laid out
in the recommendations of the Narasimham Committee (II). It would encourage practices to strengthen the sector. Its expanded role could incorporate
vigilance, improvement in accounting standards and
balance sheet practices, encouraging provisioning, and
tackling the problem of weakness and deteriorating
asset quality in the banking sector.
IBA as an SRO would have to ensure that banks
follow at least a certain minimum level of prudential
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Source: Fitch IBCA.
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Individual Rating
Deregulation has helped promote competition and
efficiency in the banking system in India and will
77
Asset Liability Management
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partite Group agreed that the term “financial conglomerate” would be used to refer to “any group of
companies under common control whose exclusive
or predominant activities consist of providing significant services in at least two different financial sectors (banking, securities, insurance).” Many of the
problems encountered in the supervision of financial
conglomerates would also arise in the case of mixed
conglomerates offering not only financial services,
but also nonfinancial services and products. Coordination between RBI, Insurance Regulatory Authority, and Securities and Exchange Board of India
(SEBI) is becoming increasingly urgent.
MATURITY MISMATCH
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In 1993, the Bank for International Settlements (BIS)
set up a Tripartite Group of banking, securities, and
insurance regulators to consider ways of improving
the supervision of financial conglomerates. The Tri-
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REGULATION OF FINANCIAL CONGLOMERATES
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have a positive impact on systemic risk in the long
run. Initially, however, deregulation has affected the
stability of the banking sector. Substantial progress
has been made toward stronger regulatory frameworks. Changes in banks’ reporting requirements,
improvement in the quality of on-site supervision, and
the establishment of credit information and loan-grading and provisioning requirements have all helped.
More important, a focus on evaluating bank solvency,
more than enforcing a set of detailed regulations, has
resulted in lower systemic risk across the board. But
there are still many instances in which neither investors nor bank supervisors are able to properly monitor an institution’s creditworthiness.
Asset quality is still the main source of risk for a
financial institution and must be carefully assessed.
There are loan classification systems in which bad
loans can be converted into good ones through restructuring and are never reported as bad by rolling
over the debt (“evergreening”). In some instances
the main factor for loan classification is performance
of payment instead of the financial position of borrower, which also creates difficulties in assessing
credit risk. Previously, DFIs in India supported new
industries through equity and loan participation, and
they usually insisted on payment of dues on existing
loans. But these payments may be diverted from
working capital sourced from cash credit facilities
from banks for their existing ventures. In this way,
defaulters could promote new industries. What is
important, therefore, is not merely payment record
but actual surplus generation by the borrowers to
qualify for investment in new ventures. Consolidated
supervision of banks and their subsidiaries is another
important area that needs to be addressed in future
regulatory framework improvements.
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A STUDY OF FINANCIAL MARKETS
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78
Interest rates have changed several times over the
past seven years causing maturity transformations
in assets and liabilities and their frequent repricing.
A clear and continuous statement of rate sensitive
assets and rate sensitive liabilities has to form the
basis of interest rate risk management. RBI is expected to issue guidelines that show that management-driven asset liability management (ALM) initiatives in banks are absent. This is also the reason
why India’s money market has remained mostly as a
call money market that is meant for clearing day to
day temporary surpluses and deficits among banks.
Traditionally, many banks, including the foreign banks,
have used “call” money as a regular funding source.
PSBs are notably absent players in the market for
term funds since they lack data on maturity gaps and
interest rate gaps to be complied under ALM discipline. The common complaints about difficulties in
collection of data from hundreds of rural and semiurban branches will not be combated unless there is
computerization in these branches to facilitate data
compilation progressively.
According to RBI and many PSBs, about 80 percent of deposits are term deposits (one to three
years). Long-term lending (three to five years) comprises about 30 percent of total loans and thus, matu-
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The importance of more sophisticated ALM has increased for Indian banks in view of liberalization of
interest rates and business activities, limits to the
expansion of lending volume, introduction of derivatives, prevailing international discussions concerning
risk management, innovation of computer technology, and globalization. In ALM, risks in the banking
account (which comprises the traditional banking
products including deposits and loans and the trading
account, which mainly comprises short-term trading
products such as foreign exchange and investments)
are managed separately. The primary focus is on
how to hedge the passively arising interest rate risk
in the banking account.
However, given the changes in the business environment, Indian banks and financial institutions have
to move forward to maximize profits through comprehensive measurement and management of market risks, particularly interest rate risk, by
• upgrading the risk management measures for
banking and trading accounts, thus integrating the
risk measurement for the institution as a whole;
• shifting the focus of ALM in the banking account from simply hedging risks to actively taking and controlling risks; and
• reviewing organizational structure to make risk
management more sophisticated and provide for
more flexible ALM operations.
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SOPHISTICATION
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ASSET LIABILITY MANAGEMENT
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rity mismatch is not a serious issue. However, this
claim may not be valid as maturity of deposits and
term loans are not disclosed. Moreover, banks have
invested a large portion of funds in Government securities and debentures (long-term assets). RBI
should highlight and address the real maturity mismatch issue. Call money market is an age-old terminology that RBI itself has to stop referring to in its
publication. The “call” segment of the market is different from the “term” segment in all sophisticated
market centers in the world.
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THE INDIAN BANKING SECTOR: ON THE ROAD TO PROGRESS
An example of such organizational structure review is strengthening the authority of a financial
institution’s ALM committee, or by establishing an
ALM expert section or a middle office. Risk management can shift from the worst method of controlling the market risks related to assets and liabilities to an integrated risk management measure incorporating the credit risks in the banking and trading accounts. This shift would enable objective assessments of profitability and, based on these assessments, a strategic allocation of resources could
be carried out.
In general, the development of ALM operations
has to be in the direction of an objective and comprehensive measurement of various risks, a pursuit
of returns commensurate with the size of the risk,
and a strategic allocation of capital and human resources based on the risk. This can be said to be the
key to successful ALM in an era of financial liberalization. Unless Indian banks and FIs adopt these principles, there can be little progress in the following
critical ALM operations:
• upgrading of trading techniques;
• implementation of flexible ALM operations in the
banking account, such as strategic risk-taking operations that use interest rate swaps and investment securities and strategic pricing of mediumto long-term deposits, as well as the concentration of interest rate risk at the head office through
a review of the interoffice rate; and
• with regard to customer business, the provision
of various financial services based on improved
market risk management ability—for example,
the development of new types of deposit and
loan products involving the use of derivatives and
the provision of ALM services—and the search
for new clients among small- and medium-size
firms through sophisticated credit risk management techniques.
The evolution in financial management in terms
of sophistication in ALM operations has to be an
autonomous response and not driven by regulators.
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Banks are required to comply with the SLR by investing in approved securities, e.g., central Government bonds, Treasury bills (T-bills), and state government bonds. Moreover, banks invest in PSU
bonds, corporate debentures, and equities (limit is
5 percent of the increase in the previous year’s deposits). Investments are assessed at market prices.
As for approved securities, only 60 percent of outstanding are assessed at mark-to-market. It is difficult to identify the actual asset position of banks if
approved securities are not assessed at market price.
For this reason, RBI is planning to require banks to
assess 100 percent of the approved securities at markto-market in a few years.
These regulations are based on the Government’s
objective of bringing down fiscal deficit. It recognizes the fact that it is simply not feasible for banks
and FIs to increase the share of Government securities in their portfolio without affecting their own viability and indeed the viability of the productive sectors of the economy.
Despite the progressive reduction in the SLR over
the past five years in the wake of implementation of
Narasimham Committee (I) recommendations, banks
voluntarily directed high deposits growth into riskfree assets of Government securities. This trend coincided with companies raising external commercial
borrowings and issuing GDRs in international markets in preference to borrowings from banks. Backtracking during previous changes in government on
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RISK ASSESSMENT OF INVESTMENT
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Single customer limits are set at less than 25 percent
of net worth of the bank for a single customer, and
less than 50 percent of net worth of the bank for a
group. By definition, a loan includes debentures issued by the customer. As loans of PSBs are limited,
they would be able to comply with these ceilings.
However, small private banks may exceed these
ceilings if proper supervisory measures are not undertaken.
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SINGLE CUSTOMER LIMIT
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A STUDY OF FINANCIAL MARKETS
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80
efforts to curb the fiscal deficit caused monetary
policy to be tight and interest rates to remain high.
Now that an industrial slowdown has set in, RBI has
concluded that nothing should be done to dampen
the emerging signs of incipient recovery and focus
should be largely on strengthening balance sheets of
banks and financial institutions.
Excess investments made by banks in Government securities point to the fact that investable surpluses have not been adequately deployed to finance
industry and trade. Clearly, banks have been unable to predict interest rate changes, the root cause
being that ALM has been neglected. Through
1993/94 to 1997/98, PSBs invested in Government
securities in excess of SLR requirements by an average of 6 to 7 percent. The trend continued even
through periods of high growth in the economy when
the overall GDP grew at more than 7 percent. The
growth in SLR securities with the banks in excess
of the requirement has been high. PSBs had
excess Government securities to the tune of
Rs160.68 billion in March 1994. This grew to
Rs227.15 billion by March 1995, Rs316.77 billion
by March 1997, and Rs408.74 billion by March 1998.
Investments in Government securities are totally
risk free over a certain period. Banks can end up
making large provisions if interest rates rise consistently over several years. This would depreciate the
heavy portfolio acquired, as was demonstrated in 1995
and 1996 when Government securities depreciated
as interest rates perked up. Based on their experience, RBI has begun to assign some risk weight to
Government securities to discourage banks from
buying heavily into them.
Assigning risk weight to Government securities,
however, contradicts the statutory requirement of
maintaining minimum liquidity in Government securities investments. Also, balance sheets would not be
strengthened significantly nor would the attraction
of investing excess funds in Government securities
be removed. Instead, banks should have strong ALM
practices and risk management system in the com-
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ments but the regulatory and risk management apparatus is not fully ready.
DEPOSIT INSURANCE PREMIUMS
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Banks in India need a new attitude toward the scope
and extent of different types of risks. These risks
are made up of the dynamics between many conflicting parameters—for example, balancing the
needs of market constraints, industries, and geographic concentrations with the individual requirements of counterparties and corporate customers.
Information to support such understanding has not
historically been defined nor kept within banks’ systems. Trading portfolios of banks in India are becoming diverse with the range of bonds, equities, and
derivative instruments, and allowance made by RBI
permitting investments in overseas markets. Debt
swaps and interest rate swaps as well as currency
swaps are entered into with foreign banks and such
exposures need special monitoring. There is an eagerness to introduce a variety of derivative instru-
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TRADING RISK MANAGEMENT
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mercial lending area. RBI and Government should
improve bank balance sheets by removing contamination effect of NPAs in the form of Governmentguaranteed loans; i.e., by issuance of special Government bonds in favor of banks for converting such
NPAs into Government debt.
The conflicting considerations—the need to reduce monetary expansion while at the same time
nurturing real growth—starkly illustrate the monetary policy dilemma that RBI faces. It has not proposed to change the CRR or interest rates, and will
continue to manage liquidity through open market
operations and repo operations. RBI will not hesitate to resort to further monetary tightening if inflationary pressures increase or if external developments warrant. Going a step beyond the recommendations of the Narasimham Committee (II) on
introduction of market risk to Government and approved securities, an additional risk weight of
20 percent on investments in Government-guaranteed securities of Government undertaking that do
not form part of a market borrowing program is
also being introduced.
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THE INDIAN BANKING SECTOR: ON THE ROAD TO PROGRESS
The banking crisis that plagued the US during the
1980s was instrumental in drawing the attention of
policy makers to the fact that the system of deposit
insurance has to be reformed. In the absence of
deposit insurance, banks are vulnerable to a run that
will precipitate a liquidity crisis in the financial system. As a consequence, most Governments implicitly or directly guarantee the deposits in their respective banking systems. However, deposit insurance can lead to problems in the form of an increase in the proportion of credit disbursed to risky
borrowers.
This realization led to a reform of the deposit
insurance regime in the US with the enactment of
the Federal Deposit Insurance Corporation Improvement Act, which imparts greater autonomy on the
banks. The Act provides that “as long as it appears
that a bank will be playing with its own money (capital), almost any activity that can be adequately
monitored by the insurer could be permitted. But if
the structured early resolution fails, early resolution
is required through recapitalization by current shareholders, sale, merger or liquidation before the
institution’s capital turns negative.” Clearly, the Act
aims to eliminate agency problems by ensuring that
the losses are restricted to the shareholders, and do
not spill over to affect the depositors or the Government’s budget.
In India, however, the Narasimham Committee
(II) has recommended differentiated premium rates,
which would amount to broadcasting to the public
the status of banks. An alternative would be for the
deposit insurance system to extend rebates to banks
showing improvements and deduct the rebate amount
from the next year’s premium. Rebates would be on
the basis of annual performance whereas penal premium rates would operate only after deterioration is
detected.
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Capital adequacy is a self-regulatory discipline and
cannot save banks that are distressed. As such, the
time required for meeting bank capital adequacy must
be shortened to a minimum. The CAMEL rating system clearly recognizes the strength of bank capital
as just one requirement and also an end product of
other processes, mostly management driven. It is
essential to amplify the quality of earnings as it is the
first thing that catches shareholders’ attention. History shows that banking problems germinate during
years of economic boom. When the earnings component becomes volatile and susceptible to sharp
growth that is not sustainable, the quality of loan/risk
assets can become suspect.
PSBs are owned by the Government, therefore,
they have implicit guarantees from the Government,
resulting in the lack of capital adequacy ratio
(CAR) norm. Given the recommendation of the
Narasimham Committee (I) in 1991 on the BIS standard of capital adequacy, a CAR of 8 percent was
to be achieved by March 1996. Twenty-six out of
27 PSBs had complied with this requirement as of
March 1998.
Narasimham Committee (II) recommended CAR
targets of 9 percent by 2000 and 10 percent by 2002.
As many PSBs have already high CARs (some indicated an average CAR of about 9.6 percent as of
March 1998), such targets could be attained. Moreover, as 35 percent of deposits are allocated to CRR
and SLR, coupled with investment in Government
guaranteed bonds, risk assets are not preferred.
However, RBI has introduced a calculation method
that 60 percent of approved securities should be markto-market, and the ratio will be raised to 100 percent
in a few years. Despite the higher mark-to-market
ratio, many banks increased investments in approved
securities to comply with CAR.
The banks will have difficulties raising more capital in the near future, with capital markets sluggish,
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CAPITAL ADEQUACY
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Function of Bank Capital
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A STUDY OF FINANCIAL MARKETS
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82
investor confidence low, and bank issues unpopular
with investors. The need for general provisioning on
standard assets increases the pressure on profitability of banks as Government-guaranteed securities
are prone to default.
RBI has decided to implement certain recommendations of Narasimham Committee (II).
• Banks are to achieve a minimum of 9 percent
CAR by 31 March 2000. Decisions on further
enhancement will be made thereafter.
• An asset will be treated as doubtful if it has remained substandard for 18 months instead of 24
months. Banks may make provisions in two
phases. On 31 March 2001 provisioning will be at
not less than 50 percent on the assets that have
become doubtful on account of the new norms.
• On 31 March 2002, a balance of 50 percent of
the provisions should be made in addition to the
provisions needed by 31 March 2001. A proposal to introduce a norm of 12 months will be
announced later.
• Government-guaranteed advances that have
turned sticky are to be classified as NPAs as
per the existing prudential norms effective 1 April
2000. Provisions on these advances should be
made over a period of four years such that existing/old Government-guaranteed advances that
would become NPAs on account of new asset
classification norms should be fully provided for
during the next four years from the year ending
March 1999 to March 2002 with a minimum of
25 percent each year. To start with, banks should
make a general provision of a minimum of
0.25 percent for the year ending 31 March 2000.
The decision to raise further the provisioning requirement on standard assets shall be announced
in the process.
• Banks and financial institutions should adhere
to the prudential norms on asset classification,
provisioning, etc., and avoid the practice of
evergreening.
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lenges to bank management. The time frame allowed
for adjustments seem to be insufficient since profitability cannot be raised rapidly enough to accommodate additional provisioning and still be considered
attractive by investors. This raises a question on how
far banks will actively support growth through new
financing initiatives. Clearly, additional returns to inject better profitability in the short run have to come
from (already shrunk) avenues of short-term financing and not from new industrial and infrastructure
projects, which entail long gestation periods.
TIER-2 CAPITAL FOR BANKS
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• Banks are advised to take effective steps for
reduction of NPAs and also put in place risk management systems and practices to prevent reemergence of fresh NPAs.
• PSBs shall be encouraged to raise their tier-2
capital, but Government guarantee to bond issues for such purpose is deemed inappropriate.
• Banks are advised to establish a formal ALM
system beginning 1 April 1999. Instructions on
further disclosures such as maturity pattern of
assets and liabilities, foreign currency assets and
liabilities, movements in provision account, and
NPAs, will be issued in due course.
• Arrangements should be put in place for regular
updating of instruction manuals. Compliance has
to be reported to RBI by 30 April 1999.
• Banks are to ensure a loan review mechanism
for large advances soon after their sanction and
continuously monitor the weaknesses developing in the accounts in order to initiate corrective
measures in time.
• A 2.5 percent risk weight is to be assigned to
Government/approved securities by March 2000.
• Risk weights to be assigned for Governmentguaranteed advances sanctioned effective 1 April
1999 are as follows:
– central Government: 0 percent;
– state government: 0 percent;
– governments that remained defaulters as of
31 March 2000: 20 percent; and
– governments that continue to be defaulters after 31 March 2001: 100 percent.
The latest figures (as of 1997/98) for banks’ and
selected financial institutions’ capital adequacy are
shown in Tables 19 and 20. Table 19 indicates that
most PSBs have comfortable CARs but once the
accounts are recast in conformity with the forthcoming provisioning norms, banks will have to start planning for capital issues. The size of bank issues, sequencing, and readiness of the capital market to absorb all public offerings will pose tremendous chal-
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THE INDIAN BANKING SECTOR: ON THE ROAD TO PROGRESS
To meet CAR requirements, seven banks—Canara
Bank, Punjab National Bank, Central Bank of India,
Indian Overseas Bank, United Bank of India, Federal Bank (private sector), and Vijaya Bank—are
finalizing plans to raise about Rs20 billion worth of
subordinated debt, which qualifies as tier-2 capital.
The funds will be raised in the form of bonds from
the domestic private placement markets in 1998/99.
With this, the total amount of tier-2 borrowing (primarily debentures and bonds as against equity shares,
which are considered tier-1 capital) planned in
November 1998 to February 1999 might have exceeded Rs150 billion.
While RBI regulations have capped the coupon
rate on bank offerings to 200 basis points (bp) above
the coupon rate on similar Government securities,
none of these banks can hope to find market interest
at such fine rates. A five- to six-year bank borrowing will have to be capped at about 14 percent as
similar Government borrowing was effected at a
coupon of 11.78-11.98 percent in 1998-1999. However, with the top of the line FIs raising five-year
funds at 14 percent, these banks will have to offer
more incentives to investors. Public issue timing and
pricing is a new challenge for PSBs. There are reports that some banks have invested in tier-2 capital
issues of other banks and it remains to be seen how
it will affect their CAR.
83
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A STUDY OF FINANCIAL MARKETS
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Capital Adequacy Ratio of Public Sector Banks, 1995/96–1997/98 (percent)
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Table 19:
1995/96
1996/97
1997/98
11.60
9.33
9.90
8.80
8.81
9.51
12.38
9.40
9.68
5.07
11.19
8.44
8.49
10.38
2.63
11.30
8.27
neg.
5.95
16.99
3.31
8.23
8.42
7.83
9.50
3.50
neg.
12.17
8.82
10.84
9.31
10.80
11.25
12.14
8.17
11.00
12.05
11.80
10.26
9.07
10.17
9.41
11.30
10.81
neg.
10.07
17.53
9.23
9.15
8.80
3.16
10.53
8.23
11.53
14.58
10.65
10.83
9.83
11.61
13.24
18.14
11.48
11.64
12.37
12.05
9.11
10.90
9.54
10.40
16.90
11.88
1.41
9.34
15.28
11.39
8.81
10.50
9.07
10.86
8.41
10.30
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Name of Bank
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State Bank of India
State Bank of Bikaner & Jaipur
State Bank of Hyderabad
State Bank of Indore
State Bank of Mysore
State Bank of Patiala
State Bank of Saurashtra
State Bank of Travancore
Allahabad Bank
Andhra Bank
Bank of Baroda
Bank of India
Bank of Maharashtra
Canara Bank
Central Bank of India
Corporation Bank
Dena Bank
Indian Bank
Indian Overseas Bank
Oriental Bank of Commerce
Punjab & Sind Bank
Punjab National Bank
Syndicate Bank
United Commercial Bank
Union Bank of India
United Bank of India
Vijaya Bank
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Capital Adequacy Ratioa of Selected
Financial Institutions, 1997 and 1998 (%)
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Table 20:
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neg. = negative.
Source: Reserve Bank of India.
As of 31 March 1997
As of 31 March 1998
IDBI
ICICI
IFCI
SIDBI
IIBI
Exim Bank
NABARD
14.7
13.3
10.0
25.7
10.6
31.5
40.4
13.7
13.0
11.6
30.3
12.8
30.5
52.5
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Global trends in the banking industry in recent years
have focused on cost management, which drove
banks to venture into nontraditional functions, standardize products, centralize activities, and form merg-
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CONSOLIDATION OF THE BANKING INDUSTRY
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Mergers and Recapitalization
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ICICI = Industrial Credit and Investment Corporation of India, IDBI = Industrial
Development Bank of India, IFCI = Industrial Finance Corporation of India, IIBI =
Industrial Investment Bank of India, NABARD = National Bank for Agriculture and
Rural Development, SIDBI = Small Industries Development Bank of India.
a As percent of risk weighted assets.
Source: Reserve Bank of India.
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Institution
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84
ers and alliances to gain capital strength and access
to broader customer bases. Such global trends are
found in India, with the exception of consolidation.
The Indian banking system is still in the growth
phase. The impulses of consolidation are not yet seen
in private banks and much less so in PSBs whose
policies originate from the Government. Even the
merger of one PSB with another that took place five
years ago in the early period of banking sector reforms benefited neither bank.
The increasing forays of banks into new areas
and convergence of business operations of banks,
DFIs, and NBFCs raise the issue of merging banks,
based on specific business complementarities. Mergers would be determined by the size of the balance
sheet, or by efficiency, competitiveness and strategic repositioning to reduce intermediation costs, expand delivery platforms, and to operate on econo-
RECAPITALIZATION
The Government owns the core of the Indian banking sector, a factor that has contributed to its quick
recovery from capital shortage. It did not need to
adopt the complicated procedures observed in the
rehabilitation processes of Japan and Korea to inject
public funds into major banks. The Government even
helped the nationalized banks increase their CARs
(Table 21).
Table 21:
Capital Contributions by Government
to Nationalized Banksa (Rs billion)
Item
Amount
Up to March 1992
1992/93
1993/94
1994/95
1995/96
1996/97
1997–February 1998
Total
Capital Returned to Government
Net Contribution
33.00b
7.00c
57.00c
52.87b
8.50c
15.09c
27.00
200.46
6.43
194.03
a Including New Bank of India
b Capital contribution.
c Capital allocation.
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associate banks to expand in their respective regions.
Such a policy may accelerate improvement in the
population per branch ratio and also productivity.
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Source: Reserve Bank of India.
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mies of scale. The Government is disinclined to urge
mergers whereas RBI wants market forces to decide.
In the corporate world, 50 percent of mergers fail
due to cultural incompatibility of the two organizations coming together. The Government in 1996/97
favored merging banks to create megabanks of international size and competitiveness. The only merger
that materialized was five years ago between ICICI
(a DFI) and the financially ailing Imperial Tobacco
Company (an NBFC of the multinational: ITC). ICICI
had the incentive of a tax shield advantage in addition to expansion into retail business and a network
advantage. But the resulting merger was widely regarded as unsuccessful for both parties.
Mergers of international banks are being evolved
to develop synergy and worldwide international competitiveness. Indian banks have a long way to go in
this regard. The country has a lot of small banks not
interested in the global market, for they lack the required expertise. They need to remain focused on
doing what they do best—understanding their local
market base. The danger is that of becoming too
specialized, because when business drops, the difficulties start. Banks need to diversify. In the right
place and with the right focus, there is room for big
multinationals and small private banks operating within
a country. A smooth merger may be possible among
the eight state banks because of their 50 years of
staffing and management homogeneity, while small
private banks may be forced to merge to remove
diseconomies of scale.
Consolidation will remain a matter of theoretical
discussion at least until after the merger of New Bank
of India with Punjab National Bank has been studied. The problem of weak PSBs is a separate one.
Banks that were nationalized in 1969 had a regional
branch network and influence before nationalization.
Instead of mergers, they should be given freedom to
expand their branch network in regions of their choice
to facilitate relocation of staff that were rendered
surplus due to computerization. SBI has allowed its
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THE INDIAN BANKING SECTOR: ON THE ROAD TO PROGRESS
Recapitalization has been going on since 1991 in
line with the implementation of the recommendations
of Narasimham Committee (I). The total amount of
net contribution of the Government to the nationalized banks up to February 1998 was Rs194.03 billion, which was 5.5 percent of total assets as of March
1997. Needless to say, this recapitalization of the
nationalized banks has been supported by India’s taxpayers.
Additionally, some PSBs issued equity or subordinated debt to increase CARs. Three nationalized
banks (Dena Bank, Bank of Baroda, and Bank of
India) raised capital of Rs17.05 billion through public
issues. In contrast, four PSBs obtained capital by
85
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The Narasimham Committee (II) recommended a
restructuring commission as an independent agency
to run weak banks to restore them to operational
health over a period of three to five years. Also, such
banks should operate as “narrow banks,” i.e., deploy
only deposits for investment in Government securities. The recommendations ignore that the weak
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?
BANK RESTRUCTURING
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Restructuring Commission for
Weak Banks
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issuing subordinated debt. However, the precise figure of the amount of capital derived from the subordinated debt is not available.
This process of bank recapitalization was guided
by the Indian authorities because the Government
and RBI are major holders of PSBs. Thus, in theory,
there should exist no conflict between shareholders
and the regulatory authorities that monitor the process on behalf of depositors and other debt holders.
This conflict sometimes complicates and hinders the
process of disposing of distressed banks in a fully
privatized banking industry, such as that in countries
like Japan.
The public issues by PSBs suggest that the Indian
Government believes that bailout of such banks
through capital injection is costly. However, according to the recapitalization figures of nationalized banks,
the Government has not yet abandoned the policy of
restricting interface of PSBs with the capital market. It will take a long time for the capital market to
play a pivotal role in monitoring and disciplining bank
managements in India.
Meanwhile, the shortage of capital seems to be
getting worse in the cooperative bank sector although
the expert committee organized by NABARD recommends that the stringent capital adequacy norm
should be extended to cooperative banks and RRBs.
The committee recommends that the Government
rescue program should be quickly implemented to
assist cooperative banks to achieve 4 percent capital
adequacy level by the end of March 1999.
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A STUDY OF FINANCIAL MARKETS
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86
(public sector) banks are old banks and they should
be dealt with according to causes of deterioration
such as mismanagement, lack of supervision, and
political interference.
The Government and RBI instituted restructuring
exercises for weak banks detected based on the
implementation of recommendations of the Narasimham Committee (I) in 1992/93. There are only three
PSBs (India Bank, United Commercial Bank, and
United Bank of India) that still require treatment.
What has gone wrong with these banks is well known
and remedial measures should lie with individual banks
according to the nature of their respective sickness.
Since investment in Government securities now carries risk weight, narrow banking may not be the correct solution.
The weak banks must improve the bottom line of
each branch by adding earning assets. In the absence of these, they may end up with “one-legged
managers,” i.e., who know only how to raise deposits (liabilities) but are averse to risk management (of
assets). These banks are too big and rationalization
or closure of branches is not going to mitigate their
major weaknesses. A long-term solution will lie only
in financial strengthening and efficiency. Since mergers with the strong banks have been ruled out, the
Government as the owner must stand by these banks
while firmly rooting out bad managers and deficiencies. Restructuring does not have fixed rules and has
to be bank specific, depending on several factors, as
follows:
• importance of the banking system to the economy,
• methods for developing institutional arrangements,
• maturity of society, and
• political system.
Redimensioning (i.e., downsizing) by closure of
branches will go against India’s development objective of reducing the population-branch ratio. The much
neglected cooperative banking sector cannot fill the
increasing service delivery gap for a population that
is rapidly rising.
ASSET RESTRUCTURING COMPANY
Operational Efficiency
The most important problem facing Indian banks is
how to improve their operational efficiency.
Overall efficiency of the banking sector may be
measured by an index of financial deepening defined
by the ratio of total bank deposits to GDP. This index
increased substantially between the 1970s and the
mid-1980s (see Table 22). The improvement can be
partly explained by the expansion of the branch network in India.
Table 22:
Financial Deepening
Year
Deposits/GDP (percent)
1970
1975
1980
1985
1990
1991
1992
1993
1994
1995
1996
13.4
18.0
27.8
33.6
35.7
36.9
38.4
39.1
39.6
36.2
38.3
GDP = gross domestic product.
Source: IMF, International Financial Statistics, various issues.
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The Union Finance Ministry is considering asking
the strong PSBs to set up an ARC for the weak
banks who have problems in recovering their bad
loans.
It is proposed that the debt funding of ARC be
through the issuance of Government-guaranteed
bonds. Although the Finance Ministry has not yet
taken a final decision on the modalities of an ARC,
an internal study on establishing an ARC is being
worked out.
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Developmental banking remains the need of the country and the Government should concretely demonstrate the will to back the risk-taking ventures of
banks. The ability of public sector banks to raise equity from the markets will depend upon how Government chooses to back the banks. An asset reconstruction fund (ARF) is a solution that will favor bad
banks while penalizing good ones.
The current thinking is that an ARF would be
formed for weak banks with equity contribution from
PSBs. This would amount to withdrawing equity from
such banks in times when they have to meet stringent CAR deadlines. It is the weak banks and their
borrowers who must struggle to reform the balance
sheet. Debt recovery processes in India are tortuously lengthy and ARF will not deliver goods better
than the banks and their particular branches out of
which funds have been lent.
Unlike the banking crises in Asia, Latin America,
or the savings and loans problem in the US (in 1989),
Indian banks’ NPA problem was not caused by excessive risk concentrations. The real sector (which
has been buoyant in Asia) has not undergone structural changes to be internationally competitive and
Indian banks have remained at the receiving end.
PSBs should seek conversion of nonpayable debt
obligations of the defaulting borrowers into equity
and line up cases for sale/mergers. What banks can
do in this respect, ARF will not be able to do. Instead, a lot of time will be wasted in finding equity
for ARF and assembling NPA assets from banks
for transfer to ARF. The need is to reform the real
sector and also to develop preventive controls in
banks.
The weak PSBs owned by the Government are
of the “too big to fail type” and have been in existence for nearly a century. The critical policy initiative should be to reform and recapitalize them instead of relieving them of bad debts through an ARF
vehicle.
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ASSET RECONSTRUCTION FUND
?
THE INDIAN BANKING SECTOR: ON THE ROAD TO PROGRESS
However, in spite of the branch network expansion, financial deepening still remains at a low level
(less than 40 percent) by global standards. The Indian financial deepening index is slightly higher than
those of the PRC and Viet Nam at the beginning of
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Increasing public ownership of banks will require
management to prudently handle shareholder constituencies since takeovers by speculators wanting
to make easy money or ensure financing for their
own businesses are among the potential risks. This
task lies squarely in the domain of the regulator and
corporate offices of banks. Banks as business organizations have to match up to both social expectations and stakeholder aspirations. The board of a bank
bears a principal responsibility for fashioning a governance code appropriate to its structure. It is also to
be charged with the responsibility of subjecting the
code to a periodic review to make it contemporary in
a multibusiness banking organization.
The fundamental factor that has brought boards
of directors into the spotlight is a lack of confidence
in their system of accountability. The second factor
that has focused attention on corporate governance
is the emergence of the global market. In the search
for attractive investment opportunities, the major institutional investors have moved beyond their domestic markets and are looking to spread their risks geographically. As they do so, they demand high and
consistent standards in terms of both financial reporting and the treatment of shareholders’ interest,
making boardroom accountability and standards of
corporate governance a global issue.
There are, however, no uniform global standards
of corporate governance. Nevertheless, these standards are moving forward and this is gradually leading to a greater degree of convergence between
markets. No company can afford to ignore these
developments, which are underpinned by advances
in information technology (IT) that make information about companies more widely and immediately
accessible, thus contributing to the unification of financial markets. This also very much applies to the
players in banking and other financial sectors.
Bank Computerization
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The issue of autonomy concerns mainly PSBs and
DFIs. Autonomy as a concept can be summarized
as follows:
• it calls for separation of ownership and management;
• it requires distinction between bureaucracy and
business management. In terms of accountability, this means distinguishing between performance accountability and accountability for misfeasance;
• it necessitates change in the mindset of bankers
as well as regulators;.
• banks have to ready themselves to exercise autonomy. This requires creation of knowledgeable
workers who can bring to bear upon the functioning of the bank at all its establishments the
collective wisdom of the management;
• autonomy is an inevitable fallout of deregulation;
• government or regulatory scrutiny does not
amount to “back seat driving” and does not deprive a good management of its autonomy; and
• where Government/RBI directives concern procedural aspects in place of performance scrutiny through results, then banks may suffer the
phenomenon of “back seat driving.”
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Autonomy and Governance
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their respective market reforms. This suggests that
there is plenty of room for the Indian banking sector
to increase its presence in the financial system.
Commercial banks in India will also have to service the demands of the different economic segments.
They must not ignore nor prefer to serve only one of
these at the expense of the others. Banking services
have to be designed and delivered in response to the
wide disparity in standards and ways of living of rural, semi-urban, urban, and metropolitan populaces.
For example, the banking needs of a vast majority of
the Indian population residing in the rural and semiurban areas are relatively simple. In these markets,
availability of services, timely credit, and low cost of
their delivery are needed.
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A STUDY OF FINANCIAL MARKETS
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88
Entry of new private sector banks, PCBs, and foreign banks offering most modern technology bank-
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ing has forced PSBs to address computerization problems more seriously in recent years. The pace of
computerization has remained slow even though opposition from staff unions has softened. The Central
Vigilance Commission wants 100 percent computerization in Indian banks to check frauds, delays, etc.
The general perception is that in recent years, the
prime focus of bank computerization has been less
on the number of branches computerized but more
on better connectivity, say, between the head office
and regional offices of a bank with select branches.
These are usually banks that handle large corporate
borrowing accounts on one side, and those that are
in high deposit zones, on the other.
While the private sector banks have been upgrading technology simultaneously with branch expansion, many of the top PSBs have completed automating their branches in the urban areas. The next
step to total branch automation is networking these
branches. PSBs need to frame a strategy to choose
the branches that have to be included in their networking scheme. Since it would be a daunting task
for them to connect all the 64,000 branches spread
across the country, as a first step, they are following
the 80-20 thumb rule. It assumes that 80 percent of
bank’s business is carried out by only 20 percent of its
branches. It is the branches with substantial business,
most of which lie in the urban areas, that are initially
targeted for interconnection.
A major problem PSBs have to face once IT implementation reaches its optimum level is staff retention. While the private sector banks have been recruiting trained and experienced IT professionals, it
may not be possible for PSBs to do likewise. They
will have to train their existing staff to function effectively in the new environment. And once the requisite skills are acquired by employees, they may have
trouble retaining staff. PSBs can only allocate limited capital resources to computerization. They will
have to choose between high cost of computerization at metro and urban centers and low cost computerization at rural, semi-urban branches. Also, they
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THE INDIAN BANKING SECTOR: ON THE ROAD TO PROGRESS
will have to factor in returns on IT assets, and growth
and productivity improvements.
Newly opened private sector banks, foreign banks,
and a few other Indian banks have started Electronic
Money activities, which open up business opportunities but carry risks that need to be recognized and
managed prudently. The Basle Committee on Banking Supervision has raised issues of critical importance to banking authorities in this regard. There is
no evidence that these aspects are being looked into
in India, yet there is a need for auditing firms to be
aware of this issue.
Despite recapitalization, the overall performance
of PSBs continues to lag behind those of private sector and foreign banks. Questions of ownership, management, and governance are central to this issue.
Under public ownership, it is almost impossible to
draw a distinction between ownership responsibility
and managerial duty. For this reason, Governmentowned banks cannot insulate themselves from interference. Inevitably, some PSBs are overregulated
and overadministered.
A central concern is that banking operation flexibility, which is essential for responding to changing
conditions, is difficult to implement. Under public control, the efficiency objective in terms of cost, profitability, and market share is subordinated to the vaguely
defined public interest objective.
Moreover, it is not only difficult to inject competition between PSBs since they have a common ownership, but Government-imposed constraints have
also meant that they have not been able to effectively compete with private sector banks. India still
has to find a middle path of balancing divergent expectations of socioeconomic benefits while promoting competitive capitalism.
Political sensitivities can make privatization difficult but the Government aims to bring down its holdings to 51 percent. When that happens, a great stride
will have been completed. In 1998, announcements
have been made on corporatization of IDBI and reduced Government holdings in Bank of Baroda, Bank
89
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branch” criterion is the yardstick that is routinely used
to measure the adequacy or otherwise of banking
facilities in regions that have been demographically
demarcated as follows: rural (population below
10,000), semi-urban (population between 10,000 and
100,000), urban (population between 100,000 and
1 million), and metropolitan (population above one
million).
Dividing the total population by the number of bank
branches, the population per branch has fallen from
64,000 in 1969 to 15,000 as of June 1997. This does
not take into account, however, staff redundancies
likely from computer-based banking including the
spread of automated teller machine (ATM) outlets.
Even in the most advanced branch banking and computerized banking environments such as Canada, the
ratio of population to branch is only 3,000 and if ATM
banking is included as branch-type retail outlet, the
ratio is still lower. In India, foreign banks are fast experiencing staff redundancy and aging problems but
not allowed to branch out freely into places requiring
competition, especially in foreign trade financing.
The Government needs to expand the branch network to ensure a reduction in the population per
branch ratio further to 10,000 (phase I), 5,000 (phase
II), and 3,000 (phase III) by including, if necessary,
ATMs and similar outlets as branches at metro and
urban centers.
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It would be worthwhile for RBI to reward banks
through a special subsidy for spreading a credit card
culture on the basis of the number of credit cards
and annual transition volumes. The largest bank, SBI,
did not even have a credit card until the formation of
its joint venture with GE Capital in 1998/99.
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SPREAD OF CREDIT CARD CULTURE
NARROW BANKING
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RBI currently uses only demographic data for issuing branch licenses. The “population served per
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REGIONAL SPREAD OF BANKING
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Branch investment and reengineering is often the
responsibility of operations or premises departments
with little regard for coordination with marketing departments. In order to maximize the benefits of
branch investment or reengineering, astute management teams should integrate all aspects of their brand
and its customer interface under identity management to harness the power of the bank
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INTERDEPARTMENTAL COORDINATION
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PSBs and the rural banking system have to build up
the transaction and advisory services of their
branches. In a competitive marketplace, a retail
branch environment that can project and deliver the
brand promise has become increasingly important.
As retail banks undertake strategic reengineering
of distribution and delivery strategies, product and
service enhancement and network downsizing, they
ignore the role of the branch and the power of a
brand at their peril, since the branch is a retail bank’s
shop window and platform for differentiating its products and services.
With the growth of automated transactions, the
role of the branch is changing and must reflect new
marketing and brand communication strategies. Is
the branch to be a retail opportunity drawing customers for financial services advice, or is it an outpost of technology and remote transaction efficiency?
Can the branch network provide both? The answers
lie in the strength, depth, and clarity of an
organization’s brand identity, which is the foundation
upon which a retail bank can communicate its unique
product or service.
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BRAND IDENTITY
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Importance of Branches
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of India, Corporation Bank, Dena Bank, IDBI, Oriental Bank of Commerce, and SBI.
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A STUDY OF FINANCIAL MARKETS
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90
Weaker banks have been under pressure to cease
lending and concentrate on investments in Government securities, which are subject to depreciation
risks. Narrow banking is therefore not a solution for
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quired skills and actual requirements is increasing as
more complex product mixes are introduced and traditional banking products are replaced. Another reason is the skewed age profile of employees, some of
whom were taken on 30-35 years back when the
branch expansion programs started.
Indian banks are highly unionized and productivity
benchmarks are not clearly established. To create a
more constructive work attitude, the disinvestment
or privatization programs of PSBs should include share
offerings to staff, an idea successfully carried out by
SBI, Bank of Baroda, and Bank of India, among others. The spread of computerization (so far inhibited
by staff union pressures on quotas and wage hikes)
must be evaluated in terms of return on information
technology assets of the banks and revised productivity benchmarks.
Another issue requiring attention is regular recruitment in various grades every year, since experienced
employees in banking are built up over several years.
An embargo on recruitment since 1985 has skewed
the age profile of the workforce in PSBs. Such imbalances are difficult to rectify. There are those who
argue for productivity-linked wages, which is a dangerous recipe in the context of a unionized workforce.
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The number of bank management staff and employees in India is vast (223,000 in SBI; 81,252 in SBI
Associates; 581,000 in nationalized banks; 57,241 in
old private sector banks; 1,620 in new private sector
banks, and 13,510 in foreign banks operating in the
country). The total is 957,623, with the number of
staff employed in cooperative and rural banks equally
large. Potentially, the gap between availability of re-
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LABOR UNION AND HUMAN RESOURCES
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Human Resources Issues in Banking
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Table 23 shows the Indian banks’ low coverage of
bills and receivables financing, and low level of exposure of bank clientele to the foreign trade segment. Partly these should be ascribed to a lack of
banking services or expertise of centers where demand for the services exists but is met by distantly
placed branches. Inadequate bills and direct receivables financing results in underutilization of network
branches through which collections can take place.
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Credit Delivery System
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weak banks. Enhancing the branch network can improve the bottom line and should be explored. Such
banks require all-round restructuring.
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THE INDIAN BANKING SECTOR: ON THE ROAD TO PROGRESS
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Distribution of Outstanding Credit of Scheduled Commercial Banks According to Type of Account,
March 1996 (percent)
No. of
Accounts
Credit
Limit
Amount
Outstanding
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Type of Account
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Table 23:
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Cash credit
Overdrafts
Demand loans
Medium-term loans
Long-term loans
Packing credit
Export trade bills purchased
Export trade bills discounted
Export trade bills advanced
Advances against export cash incentives and duty drawback claim
Inland (Trade) bills purchased
Inland (Trade) bills discounted
Inland (Others) bills—purchased
Inland (Others) bills—discounted
Advances against important bills
Foreign currency checks/TCs/DDs/TTs/ MTs purchased
Total
Amount (Rs billion)
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DD = demand draft, MT = mail transfer, TC = travelers check, TT = telegraphic transfer.
Source: Reserve Bank of India.
16.1
6.8
7.2
24.8
42.9
0.5
0.3
0.1
0.1
0.0
0.4
0.3
0.2
0.1
0.1
0.2
100.0
4,767,771.0
35.7
7.7
7.9
9.4
18.9
7.3
3.2
2.1
1.1
0.1
1.3
2.4
0.9
0.8
0.8
0.4
100.0
2,684.4
35.7
7.4
8.0
10.3
19.8
7.0
2.6
1.8
0.9
0.1
1.2
2.2
0.9
0.7
0.8
0.4
100.0
2,184.4
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What is needed is fair competition, merit-based career progression policies, strong management of staff,
and transparent performance evaluation systems (experience of international banks paying proprietary rewards and packages for specialist traders, etc., have
not exactly been happy since such staff have landed
some banks with losses).
The merger of banks as recommended by Narasimham Committee (II) to create strong banks that can
compete internationally can result only in the creation
of formidable union power and amplify inefficiencies.
Policies are also needed to prevent significant turnover of banking staff in cities, urban as well as semiurban and rural branches. Incentives must be given to
staff in rural and semi-urban branches to increase motivation and minimize fast personnel turnover.
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A STUDY OF FINANCIAL MARKETS
Priority Sectors
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The Chief Vigilance Commission in 1999 has clarified that banks should be 100 percent computerized
by the year 2000 and that bank unions will have no
say in this matter. This is to ensure that frauds, which
have reached serious proportions under the manual
processing system, are kept in check. The area of
computer fraud, however, is not addressed.
Foreign banks have started reducing staff under
the Voluntary Retirement Scheme. Such packages
for staff of weak PSBs remain under discussion.
Table 24 shows the number of staff deployed in
scheduled commercial banks (SCBs), and the number of deposit accounts and borrowing accounts
handled. As can be seen from the table, improvements must be made in branch service operations,
staffing, and expansion in rural and semi-urban SCBs
considering the high volume of banking transactions
and the relatively smaller number of staff per branch
compared with urban/metropolitan SCBs.
Indian banks have been assigned an important public
role of allocating financial resources to specified priority sectors, a system that has contributed to the
creation of assets, a green revolution, and a white
5
revolution, apart from strengthening the base of
small-scale industries. The level of NPAs should not
detract policymakers from supporting banks’ roles
in the development of the priority sectors. A fair,
objective assessment of socioeconomic benefits is
needed. Branch expansion in unbanked areas will
have to continue to create wealth and prosperity. The
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For the first time, the Government, RBI, and IBA
have ruled out a uniform wage increase formula
that is not linked to banks’ productivity and performance. Across-the-board pay hikes blur the distinction between good and bad performers while
operating costs continue to mount. About 80 percent of the operating expenses of PSBs are accounted for by wages and salaries. RBI data on
bank intermediation cost (BIC) ratios show that
PSBs in the period 1991-1998 recorded an average
rise in the BIC ratio, in contrast with Indian private
sector banks, which managed to hold the ratio down.
The only way forward now is for banks to be left
free to genuinely compete.
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WAGE HIKES
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Number of Offices, Deposits and Borrowing Accounts, and Staff in Scheduled Commercial Banks
(inclusive of regional rural banks), as of March 1996
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Table 24:
32,981
13,731
9,798
7,946
64,456
196,031
227,039
595,955a
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Amount of
Deposit Accounts
(Rs million)
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No. of
Staff
Amount of
Borrowing Accounts
(Rs million)
Staff/
Branch
Deposit/
Branch
Borrowing/
Branch
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Branch Location
No. of
Branches
1,019,025
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112.9
109.4
88.5
81.2
392.0
Sources: Reserve Bank of India, Indian Banks Association.
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a Includes metropolitan staff.
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Rural
Semi-urban
Urban
Metropolitan
Total
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28.8
15.9
7.0
4.9
56.7
6
17
34a
3,423
7,968
9,028
10,224
873
1,158
718
621
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remained a long haul, though the amounts required
are much smaller than those received by sponsor
banks themselves by way of recapitalization. A largescale merger would force an appropriate recapitalization, which entails only a one-time cost to the taxpayer instead of a continuous annual invisible cost
load.
Traditionally rural and semi-urban areas have been
looked upon as requiring help and lacking in competent management. This mindset in policy formulation, regulations, and procedures governing the rural
banking system has left the rural system ailing, as
was revealed during recapitalization/restructuring
exercises on RRBs, which had operated under ad6
verse regulatory constraints. Liberalization of RRBs’
activities has permitted them to participate in more
profitable businesses. A single, strong, merged RRB
setup would bring to the rural economy a well-directed banking apparatus to take care of infrastructure, export financing, and traditional businesses.
This will require better management or setting up
new RRB branches in district locations and state
capitals, regional boards, and a central board for operational policy governance. Such a bank should be
charged with developing linkages between rural and
urban centers to provide commercial banking services and not merely rural finance. Agricultural product exports are increasing, establishing the need for
new services even at rural and semi-urban level.
Unfortunately, post-reform thinking has dampened
the will of nationalized banks to serve such needs.
Reform proponents have advocated pruning of priority sector credit from 40 to 10 percent for PSBs
without considering how cooperative banks and
RRBs can fill the void that may be created by withdrawal of major players from the activity.
CLEARING SYSTEM REFORM
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RRBs (accounting for 30 percent of the branch network of SCBs) are prime candidates for merger to
create a single large rural-oriented outfit with a commercial approach and competencies.
PSBs perceive RRBs as a drag on the system.
Although RRBs sponsored by different banks are
fragmented outfits, their staff unions have successively fought and secured wage parity with the staff
of sponsor banks. As a result, there is a weak rural
banking system of branches with highly paid staff
instead of the original plan to create “barefoot bankers.” RRBs as small banks will remain fragile and
their recapitalization (Rs3.64 billion added so far to
the Rs1.96 billion of the earlier paid-up capital) has
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POSITION OF RURAL BANKS
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Rural Banking
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economic reforms cannot be molded to leave 60-70
percent of the country’s population with only a trickle
down effect from reforms.
The shackles of “directed lending” have been removed and replaced by the criteria of merit and commercial viability. Also, expansion in the definition of
priority sector, upgrades in value limit to determine
SSI status, and provisions for indirect lending through
placement of funds with NABARD and SIDBI have
lightened the performance load of banks. SSI and
export financing take place more in metro and urban
areas in a competitive environment. As such, priority sector financing is no longer a drain on banks.
There is also a need to simplify reporting formats
and cutback on paperwork. This can be done by dividing bank capital for metro/urban areas branches and
rural/semi-urban area branches, and imposing the discipline of the CAR and CAMELS model for internal
performance evaluation at regional offices supervising such branches. The cooperative banking segment
also needs urgent recapitalization support since its
entire market and client base is in the priority sectors.
Priority sector financing is a continuing priority
for survival of banks with large networks of rural
and semi-urban branches.
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THE INDIAN BANKING SECTOR: ON THE ROAD TO PROGRESS
Industrial location policy requires that apart from
notified industries of a nonpolluting nature, new industries must be set up beyond the 25 kilometer radius of any city with a population of more than
93
FRAGILITY OF NONBANKING FINANCIAL
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Nonbanking Financial Companies
COMPANIES
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Simple personal computer (PC)-based computerization of rural and semi-urban branches would cost
about Rs1.8 billion (cost of PC [Rs40,000] X No. of
branches [45,000]), or about $43 million for PSBs.
The business of these branches is largely retail and
better control on priority sector loans at these
branches requires equipment upgrades. Staff training and system upgrades at these branches would
have to follow.
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COMPUTERIZATION
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NABARD has a statutory supervisory role over 28
state cooperative banks, 364 district central cooperative banks, and 196 RRBs. It also exercises voluntary supervision over 19 state-level and 738 primary-level agricultural rural development banks by
virtue of its refinancing and developmental role. An
Expert Committee set up by NABARD in January
1998 recommended a comprehensive package of
reforms, including extending the capital adequacy
norm to cooperative banks and RRBs gradually within
a period of five years and three years, respectively.
The committee noted that a large number of cooperative banks (66) and RRBs (170) were debilitated
and not in a position to meet even the minimum capital requirements because of heavy erosion of assets.
In order to improve the prudence of bank management, the internal auditing system must be
improved systematically, for instance based on
CAMELS rating model.
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SUPERVISION
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one million. While this has forged close economic links
and sparked a daily flow of banking transactions between city and rural bank branches, the latter are not
admitted to the city’s clearing house facilities. Check
collection and related banking services are, as a result, riddled with delays, slowing down the circulation
of money and adding to the amount of paperwork,
interoffice transactions, and risk of fraud. Expansion
of city clearing systems will radically simplify banking
and reduce transaction costs of rural branches.
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A STUDY OF FINANCIAL MARKETS
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94
Unlike in other Asian economies, the nexus between
banks and NBFCs in India is not significant. From
1985 when mutual funds and merchant banking expanded, RBI emphasized that there should be an
“arms’ length” relationship between banks and their
affiliates. This “Chinese Wall” is stronger now than
ever before.
Private market lenders are considered to have
stronger incentives or greater ability to monitor borrowers, and better positioned than public creditors to
renegotiate contract terms or exercise control rights
in the event of problems.
While banks and finance companies are equally
likely to finance problematic firms, the latter tend to
serve riskier borrowers, particularly those who are
more leveraged. This is important for a country such
as India, where nationalization of banks has, in many
instances, diluted the informality that lower class of
borrowers prefer. NBFCs and informal credit markets have thrived on lack of interest in this field among
the PSBs and expanded their asset base, fed on appetite for deposits at high rates.
With strict capital adequacy, income recognition,
and NPA norms in the offing and with the SSI sector
remaining at the receiving end of the economic slowdown problems faced by large corporates, too many
restrictions on NBFCs will create only a void in the
credit chain that banks cannot fill. Like small private
sector banks and primary urban cooperative banks,
NBFCs have their place in the financial system and
this should not be subject to sweeping changes by
regulators. If depositors looking for high deposit rates
are willing to take risks, there is no need for them to
be cautioned, except in cases of frauds and misfeasance. NBFCs operate in different market segments
with relevant marketing strengths such as in leasing,
hire purchase, factoring, merchant banking, car financing, transport financing, and home financing. They
have different risk profiles as well as asset-liability
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Factoring Services
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Several companies and SSI units are often exposed
to credit risks on sales but do not have the required
competencies in receivables portfolio management.
Banks providing working capital finance do not give
adequate attention to default risks and the quality of
receivables. On the basis of recommendations of a
Government Committee on economic reforms (1985),
the system of factoring was looked into by another
committee, and factoring companies were set up as
subsidiaries by banks such as SBI and Canara Bank
in 1992. In February 1994, perhaps to give further
impetus to the factoring system, RBI directed that
banks will also have the option to undertake the activity departmentally, though at select branches of
the banks since factoring services require special
7
skills and infrastructure.
Aside from the four basic factoring services of
administration of the sellers’ sales ledger, provision
of prepayment against the debts purchased, collection of debts purchased, and covering the credit risk
involved, factoring companies can also provide certain advisory services to the client by virtue of their
experience in credit and financial dealings and access to extensive credit information.
Credit information services are highly deficient in
India and there is little sharing of information among
banks. As a financial system combining all the related services, factoring offers a distinct solution to
the problems posed by working capital tied up in trade
debts, more than 70 percent of which arise in Indian
businesses by virtue of selling “on account (A/C)
terms of payment.” This is a large volume over which
Indian banks have had poor control. Bankers are relatively slow in responding to this important aspect of
8
working capital finance management.
Policy Recommendations
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NBFCs will remain important as the Government has
tasked them to retail the sales of Government securities to the saving public. Moreover, the public will
need their services in all other areas not touched by
banks. Like banks, NBFCs may have to develop a
second tier money market in which borrowing/lending will automatically come under “credit limit” and
“credit watch” discipline of the players in similar lines
of business. Temporary cash flows must therefore
find safe, acceptable investment avenues in the second tier money market. Entities such as mutual funds
will welcome this. The gain on the whole will be
market-regulated functioning of NBFCs.
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NEED FOR INTER-NBFC MONEY MARKET
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composition. It is not pragmatic to club them together
to be subjected to a strait-jacketed regulatory regime.
RBI announced guidelines for NBFCs in January
1998. Among other things, the directives linked the
quantum of public deposits that can be accepted by
NBFCs directly to their credit rating, and the excess
deposits held were required to be repaid before 31
December 1998. The result was panic among the
public. RBI has since then modified the rules but
there is no assessment so far as to how many NBFCs
will be deemed as unviable.
Credit rating is a relatively new field in India and
public awareness of the nuances of credit rating grades
remains poor. NBFCs are mainly deposit-taking companies and a depositor has no way to secure liquidity
in the midst of a possible downgrade. Credit-rating
agencies already have their hands full with corporate
rating business and it is doubtful if NBFCs operating
in remote corners of the country can achieve ratings
to satisfy their depositors and RBI. And it is also unlikely that all NBFCs can be effectively regulated and
inspected by RBI, as the cost would be out of proportion to the risk to be controlled. The best way out for
the public affected by the dilemma would be to identify priority centers where bank branches should be
opened as alternate service providers in place of
NBFCs ceasing to operate or forced to close down.
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THE INDIAN BANKING SECTOR: ON THE ROAD TO PROGRESS
Some major issues are highlighted on the problems
of the Indian banking system arising out of the discussion so far, and quoting, where relevant, Narasimham Committee (II) recommendations.
95
PROBLEM OF THE REAL SECTOR VS.
BANKING SECTOR REFORMS
Strengthening the viability of the real sector is important for improving Indian banking and the financial system as a whole, which is but an institution to facilitate
effective transmission of policies and smooth flow of
resources within the economy. The Committee on Capital Account Convertibility has not dwelt on the impact
to the real sector of expected inflow of capital in relation to efficiency and absorptive capacity of that sector.
In short, the future of reforms will have to focus
on how the real sector and banking sector strengthen
each other.
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necessary, change in the guidelines and accounting
system should be immediately undertaken.
Banks must adopt methods of converting debt into
equities in NPA accounts whenever possible to either ensure turnaround in corporate performance or
sell equities to limit future losses. Today banks do
not have an exit route.
Analysis of NPAs needs to be carried out not only
with reference to sectoral dispersal of NPAs but also
to specific accounts of NPAs that are common in
balance sheets of banks and AIFIs, to bring about
harmonization of their recovery efforts. Among banks
and AIFIs, research into cases handled by Credit
Guarantee Schemes, Export Credit Guarantee Corporation and state-level institutions as well as by BIFR
should help to crystallize core problems of lending
systems and problem areas of economic activity.
PROVISIONS
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RBI should not relax NPA norms in response to a
slowdown in the economy. For prudential norms relating to income recognition, it should adopt the
Narasimham Committee (I) recommendation to
gradually shorten norms from 180 to 90 days for incomes that stop accruing to be classified as NPAs.
Asset quality improvement should take place by
tightening norms for classifying assets from substandard to the doubtful category. The downgrading of assets in the Indian system is lax as the move
from substandard to doubtful category is made only
if it is past due for 30 months or remains in the
substandard category for 24 months. This has to be
improved upon. Also, the quantifiable criterion for
defining a weak bank should be: accumulated losses
+ net NPAs exceeding the bank’s net worth. Payment defaults by borrowers are mainly due to neglect of the receivables portfolio of their current
assets, a reason why banks ought to seriously launch
factoring and receivable portfolio management services to improve velocity of receivables and the
overall credit quality.
Net NPAs have to be brought down to below
5 percent by 2000 and to 3 percent by 2002. However, banks with international presence should reduce gross NPAs to 5 and 3 percent by 2000 and
2002, respectively, and net NPAs to 3 and 0 percent
by the same period.
As discussed previously, RBI guidelines stipulate
that interest on NPAs should not be charged and
considered in the income account. The guidelines
create some complications in the accounting system.
For instance, if a loan has turned into an NPA shortly
before the end of a financial year, the interest payments during that and the previous financial years
are considered not yet earned and the corresponding
book entries recognizing interest income should be
reversed. The definition of income recognition has
become a critical issue in presenting a clear picture
on the profit/loss account of banks. A review and, if
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ASSET CLASSIFICATION
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Nonperforming Asset Management
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A STUDY OF FINANCIAL MARKETS
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96
Prudential norms requiring general provision of at
least 1 percent on standard assets must be established. Also, the general provision should consider
potential loss assets determined through historical
accounts. International banks practice different general provision standards and these should be examined. General provision should also include tax holidays to be granted as an incentive to banks, to accelerate strengthening of their capital base.
Regulation and Supervision
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to “substandard”, and vice versa, as a measure of
the quality of management.
The Indian system of governance (in the public
and private sectors) has long fostered a climate of
resistance to bankruptcy and also a tendency to provide bailouts that distort the risk. As such, the reform process will be a long haul. The sequencing
may not be perfect and will necessitate adjustments.
Restructuring will also be required separately for institutions remaining in difficulty. Real sector reforms,
especially in terms of international auditing standards,
accounting, timely and accurate information to markets, and good governance practices, must be aggressively pursued to support improvements in the
soundness of the financial system.
REGULATORY FRAMEWORK
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There should be consolidation of balance sheets of
different entities of banks to reveal their strength and
to disclose connected lendings, pattern of assets and
liabilities (domestic and foreign) in different maturities, and NPAs. Some banks overseas are required
to publish cash flows, a practice Indian banks have
started. The disclosure should also include migration
patterns of asset classification, e.g., from “standard”
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Disclosure, Accounting Framework,
and Supervision
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Raising interest rates and reflating the economy
through increased Government expenditure must be
avoided. The risks to the banks and financial institutions come from NPAs that may be generated by a
continued industrial slowdown. Thus, NPA management can be carried out by maximizing attention to
the extent of credit concentration and considering
diversification of credit portfolios through consumer
financing, housing loan provision, factoring, and agricultural and SSI financing.
Management of NPAs should also focus on improving management culture that permeates various
organization levels instead of being restricted to concerns on recovery, capital adequacy, and accounting
processes. The NPA problems and their consequences will need to be assessed on the extent of
mismanagement, including fraud.
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MANAGEMENT
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FOCUS ON NONPERFORMING ASSET
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A risk weight of 5 percent should be applied to
investments in Government and other approved securities to hedge against market risk. Also, the entire
portfolio should be marked to market in three years.
Other non-SLR investment assets of banks need to
be brought in line with risk weights assigned to loans
and advances.
A 100 percent risk weight must be applied to foreign exchange open positions. Gap management is
needed to correctly reflect foreign exchange risk
exposure.
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THE INDIAN BANKING SECTOR: ON THE ROAD TO PROGRESS
The Narasimham Committee (II) suggested that the
“Basic Core Principles of Effective Bank Supervision” be regarded as the minimum to be attained.
Banks must be obligated to take into account market
risk weights to foster a sound and stable system.
For RBI to effectively carry out its monetary policy,
delineation of supervision/regulation from monetary
policy is required. The executive associated with
monetary authority should not be in the supervision
board, to avoid weakening of monetary policy, or
banking regulation and supervision. The separation
of the Board of Financial Supervision (BFS) from
RBI has to be initiated to supervise the activities of
banks, FIs, and NBFCs. A new agency, the Board
for Financial Regulation and Supervision (BFRS),
would have to be formed. To bring about integrated
supervision of the financial system, the Narasimham
Committee (II) recommended putting urban cooperative banks (UCBs) within the ambit of BFS and
proposed prudential and regulatory standards besides
new capital norms for UCBs.
The Narasimham Committee (II) recommended
amendments to the RBI Act and Banking Regulation Act with regard to the formation of BFRS. It
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The likely conflict between monetary policy and supervisory concerns can be taken as the basis and the
rationale for combining the two functions. Separate
authority structures for the two functions have more
likelihood of coming into conflict with each other.
The regulatory and supervisory systems have to take
into account peculiarities of the banking and financial structures. For instance, India’s RRB structure
is vast, its cooperative movement quite strong, but
banks in this sector are generally quite weak.
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SEPARATING SUPERVISION
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The BIS Tripartite Group agreed that the term “financial conglomerate” should be used to refer to “any
group of companies under common control whose
exclusive or predominant activities consist of providing significant services in at least two different financial sectors [e.g., banking, securities, insurance].”
Many of the problems encountered in the supervision of financial conglomerates arise when they offer not only financial services, but also nonfinancial
services and products. Coordination between RBI,
Insurance Regulatory Authority, and SEBI is increasingly urgent.
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REGULATION OF FINANCIAL CONGLOMERATES
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also gives more autonomy and powers to PSBs (Nationalization Act). As the changes in the legal framework affecting the working of the financial sector
sought by the Narasimham Committee are wide ranging, an expert committee could be constituted.
Regulation and supervision have been strengthened through prescriptions that include the establishment of a statute for BFS. Independence and autonomy of BFS would not be impaired by being a
part of RBI. What is important is autonomy for the
RBI and dilution of Government ownership in banks.
Some legislative action may be needed to support
the banking regulatory framework reforms. The reform issues should be examined by research institutions dealing with banking concerns.
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A STUDY OF FINANCIAL MARKETS
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98
Creating equal opportunities for banks and FIs has
been slow. As a result, financial packaging and closure of projects (term loans and working capital)
suffer. Progress on this structural reform has to be
constantly monitored. IDBI, ICICI, and IFCI should
move toward acquiring banking licenses to provide
one-stop services. Since the 1960s, there has existed an unnatural divide between term-lending functions and working-capital finance. The solution lies
in putting in place stringent credit monitoring in which
banks and FIs should share their expertise and information.
There is no need for a super regulator as rec9
ommended in 1998/99 by the Khan Committee,
which examined harmonization of roles/functions
of banks and FIs. RBI should remain the sole regulator to ensure that the financial system is well
supervised and that the risks of the real sector do
not get transmitted to the financial sector by default. The current worries about strengthening of
the financial system stem more from the industry’s
lack of transparency, corporate governance standards, and accountability to shareholders. Requiring disclosure for quarterly results is changing this
situation and making the information flow to investors more orderly. This requirement applies now
to banks and FIs that have raised public money.
Consequently, tightening of the financial system will
be accelerated.
In 1998/99, the World Bank issued a directive that
international audit firms cannot put their name to
accounts of Indian companies that are not in line with
high quality international financial reporting standards.
Standards are indeed low but implementing the World
Bank directive would not be practicable without Government legislation on standardization of various reporting systems and their incorporation into the Companies Act. The Government has to quickly remove
these bottlenecks to boost investor confidence, attract foreign direct investment, and minimize damages to the financial sector.
TRADING RISK MANAGEMENT
The trading portfolio of banks in India is becoming
more diverse with a range of bonds, equities, and
derivatives available, and RBI permitting investments
in overseas markets. Debt swaps and interest rate
swaps as well as currency swaps are entered into
with foreign banks and such exposures need special
monitoring. There is an eagerness to introduce a variety of derivatives but the regulatory and risk management apparatus is not fully ready.
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unless banks introduce factoring, the legitimate bank
credit needs of such borrowers will remain unmet.
Deficiencies of Indian bills and money markets have
persisted despite reports by high-level committees
during the late 1980s. The quality of receivables continues to be unsupervised and securitization is still a
remote possibility.
INTERNAL AUDIT MACHINERY AND COMPLIANCE
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In order to promote bill culture and the secondary
market, RBI directives require borrowers to resort
to bill financing to a minimum of 25 percent of receivables. Most borrowers, especially among SSIs,
find compliance difficult and it is not known how many
are forced to forgo financing from banks and resort
to market borrowings. The “on account payment”
invoicing is the dominant trade practice in India and
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BILL CULTURE
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In general, the development of ALM operations has
to be in the direction of an objective and comprehensive measurement of various risks, a pursuit of returns commensurate with the size of the risk, and a
strategic allocation of capital and human resources
based on the risk. The evolution in financial management with the sophistication of ALM operations has
to be an autonomous response and not driven by regulators.
As banking and financial sector reforms have been
under way in India for the last six years, the only
factor that could affect their balance sheets is lack
of ALM in terms of maturity and interest rate mismatches. Banks will have to participate actively in
forming money markets and to enforce data generation at each branch level. RBI, in its Monetary and
Credit Policy Review (30 October 1998), announced
the introduction of interest rate swaps but these will
be used only when banks discover the extent of mismatches that cannot be cleared through term-money
markets.
With respect to “off-balance sheet” assets, there
will be a need to create a corporate level knowledge
base in banks about items that offer “price risk transferring” or “credit risk transferring” or both opportunities. Examples of the former are swaps, futures,
options and loan caps, forward rate agreements, and
credit enhancing guarantees. Credit risk transferring
opportunities include letters of credit and note issuance facilities.
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FOCUS ON ASSET LIABILITY MANAGEMENT
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Asset Liability Management
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THE INDIAN BANKING SECTOR: ON THE ROAD TO PROGRESS
There are dangers in banks’ practice of cosmetic
cleaning or “evergreening” of advances to prevent
10
NPAs. In 1996/97, the Jilani Committee observed
that banks’ internal audit machinery and compliance
are weak. RBI stipulates that audit committees of
boards should seek to ensure management’s commitment to internal audit control. This can be made
stronger by stating that internal audits are management’s reporting responsibility to stockholders. The
internal auditing system should be established by training bank inspectors and rotating their assignments.
With regard to computer audits, SBI and IBA have
been doing work in this area since 1987. Computer
audit skills are lacking even in India’s chartered accountant firms. It is worth having computer audits as
a statutory requirement. In the US, the Federal Reserve and FDIC have jointly issued manuals on electronic data processing audit on the grounds that “technology changes the way business is done in banks.”
The computer audit of computer service agencies
by banks employing them is mandatory (with respect
to outsourced work).
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pact of reforms initiated in the first phase. But as the
reforms were introduced in stages, it is too early to
assess their impact. What has been achieved is transparency with respect to banks’ financial statements,
bringing Indian accounting standards closer to internationally accepted norms. One discernible impact
has been that all but two PSBs (Indian Bank and
United Commercial Bank), had met by 31 May 1997
the capital adequacy norm of 8 percent and some
are already well above that threshold. For instance,
that for SBI is 14.58 percent; UBI, 10.86 percent;
BOI, 9.11 percent; DenaBank, 11.88 percent; and
IDBI, 13.7 percent. The weaknesses that have
emerged in the banking system are in fact weaknesses of the prereform period. The issues to be tackled in the second phase of reforms are large and
cannot be delayed because the adjustment process
would become increasingly difficult. As far back as
1961, RBI advised banks to aim for a CAR of 6
percent (of paid-up capital and reserves to deposits)
because they had been increasing their assets without a corresponding augmentation in the capital base.
This ratio declined from 9 percent in 1950 to 4 percent in 1960, and 1.5 percent in 1978.
Mergers and Recapitalization
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A capital adequacy of 9 percent should be achieved
by the year 2000 and 10 percent by 2002. This goal
should be weighed against the expected financial
support from banks for economic growth and protection of risk assets. In the first phase of reforms
(1991-1997), banks changed their approach from
“growth budgeting” to “balanced growth budgeting”
(i.e., with reference to their own funds). The dilemma
of banks’ shortage of capital to cope with increasing
credit demand must be resolved as a priority so that
capital adequacy does not become an end in itself.
Measures should not be implemented in isolation.
If the capital adequacy levels are being brought to
international levels, then the concept of a tier-3 capital should also be introduced, i.e., as a subordinated
debt instrument (of shorter maturity of two years)
much like the bonds issued towards tier-2 capital (of
five years maturity).
Other measures to strengthen banks should seek
to eliminate the management dilemma. This can be
done if banks themselves internalize a culture of selfevaluation under the CAMELS model by undertaking periodical management audits. The core message of capital adequacy and prudential norms is selfregulation.
Measures to be taken in the second phase of banking reforms should be based upon a study of the im-
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Capital Adequacy
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Certification of Information Systems Auditors
(CISA) examinations from the US are now available in India, but few bank staff take them. Banks’
inspectorates and chartered accountant firms should
have CISA qualified auditors.
Similarly, banks, nonbanks, and companies require
professionals qualified in handling foreign exchange
trading. In fact, RBI has taken the lead to define risk
management standards in PSUs that take on foreign
exchange exposure.
There is also a need for professionals qualified to
carry out securities and stock market trading in all
the market intermediaries.
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A STUDY OF FINANCIAL MARKETS
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100
The Narasimham Committee recommended that after the activities of DFIs and banks have converged
for a period, the DFIs should be converted into banks,
leaving only two types of intermediaries—banks and
nonbanks. While mergers between strong financial
institutions would make sense, the weak banks in the
system would have to be given revival packages.
The licensing of new private sector banks needs to
be reviewed, while foreign banks will have to be encouraged to extend their operations.
The importance of the tasks ahead is underlined
by the fact that Government recapitalization of nationalized banks has cost Rs200 billion. SBI has been
an exception particularly because it has addressed
(since 1974) the task of reflecting its financial strength
through the building of reserves. This is due to the
FISCAL IMPLICATIONS
All bank restructuring attempts have fiscal implications that are bad if considered in isolation. The advantage lies in taking on the fiscal impact and not
allowing problems to fester. The Government should
draw up a total balance sheet of bank nationalization
and socioeconomic gains to strengthen PSBs, on
which it will have to depend if it is to reduce the
11
population/branch and ATM ratio from 15,000 to
3,000.
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Bank Restructuring
ASSET RECONSTRUCTION COMPANY
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requirement to raise lines of credit in the international market for itself and for Indian corporates. SBI
has done this regularly for some years since 1972. It
was late in establishing offices overseas but quickly
caught up with international standards of management. One factor that has helped SBI has been the
private shareholdings held in it even after 1955 when
RBI acquired a majority share. As a result, SBI has
been required to hold annual general meetings of
shareholders and has benefited from the system of
checks and balances, disclosure disciplines, and dividend expectations of shareholders.
With most nationalized banks incurring continuous losses since 1992/93, returns on capital have been
negative, preventing buildups of reserves. Slow accretion in reserves was also due to higher provisioning requirements under the new prudential norms.
With the Government no longer willing to provide
further capital, the only route for PSBs to improve
their capital base is through substantial improvement
in generation of internal surplus so as to be in a presentable shape to approach the capital market. These
features and the weaknesses of the rural banking
system should determine the measures required in
the second phase of reforms.
Government-guaranteed advances that have turned
sticky should be classified as NPAs and, in cases where
sovereign guarantee argument is advanced, there
should be appropriate disclosure in the balance sheet
of banks. Potential for conversion of such loan assets
into Government debts in the form of securities issued
to banks should be looked into as a way of removing
contamination from banks’ balance sheets. This way,
a loan asset in a bank’s balance sheet would be transformed into an investment asset.
The measure would not only help to clean up bank
balance sheets but also strengthen the Government’s
resolve to eventually sell off or privatize the business
units for which the Government provided a guarantee to a bank. This will in turn contribute to an improvement in the recovery climate.
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THE INDIAN BANKING SECTOR: ON THE ROAD TO PROGRESS
The Government should not provide capital support
or indirect financing to ARCs. The Narasimham
Committee (II) recommended that there should be
no further bank recapitalization other than the undisbursed amount of Rs4 billion from the previous
budget provision that can be diverted as seed capital for ARCs. ARCs will be required for banks that
are not viable over a three-year period. Such banks
will have to be referred to the Restructuring Commission.
The Narasimham Committee proposed the establishment of ARCs to tide over the backlog of
NPAs. Banks would undertake financial restructuring by hiving off their NPA portfolios to ARCs
and obtaining funding from it through swap bonds
or securitization. But the Indian banking sector does
not require any emergency policy for rebuilding,
despite the NPA problem. The only banks that need
to be recapitalized in the near future are some rural
and cooperative banks. The dangers of ARCs are
obvious since it could prove to be an easy route for
commercial banks to clean up their balance sheets,
creating scope for staff to repeat mistakes instead
of learning from them.
Banks have managed recoveries and creation of
ARCs would only reverse the healthy recovery of
management systems that banks are hoping to establish.
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Systems and methods in banks should be improved.
Some of the issues are at the micro level and best
achieved if banks internalize the system of self-evaluation under the CAMELS rating model.
Banks also need to effectively exploit their networks of branches established in the past at low cost.
It is necessary for PSBs to introduce factoring services and also activate a short-term bill financing
mechanism, both of which entail utilization of the
branch network for collection of the factored invoices
and bills for clients.
Autonomy and Governance
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The private sector’s partial ownership of SBI has
contributed to its exceptional operational efficiency
even after 1955 when RBI acquired majority shares.
This suggests that it is advisable in the long term for
the Indian banking sector to increase the share of
private ownership.
In order to reduce the social burden caused by banking sector inefficiency, banks should be given wider
management autonomy. The Government should gradually but steadily reduce its ownership of the banking industry while maintaining rigorous prudential
regulation and rationalizing its supervision capacity.
To bring about efficiency in banks, the Narasimham
Committee (II) recommended a number of measures.
These included revision and regular update of operational manuals, simplification of documentation systems, introduction of computer audits, and evolution
of a filtering mechanism to reduce concentration of
exposures in lending and drawing geographical/industry/sectoral exposure norms with the Board’s concurrence. Besides, the Narasimham Committee suggested the assignment of full-time directors in nationalized banks. As outsourcing of services would
improve productivity, it recommended that the same
be introduced in the fields of building maintenance,
cleaning, security, dispatch of mail, computer-related
work, etc., subject to relevant laws. It also suggested
that the minimum stipulated holdings of the Government/RBI in the equity of nationalized banks/SBI be
reduced to 33 percent.
With regard to the tenure of a bank’s chief executive, the Narasimham Committee indicated a minimum period of three years. However, a more reasonable length of tenure should not be less than five
years. Managers should be given incentives to adapt
their managerial structure to new developments in
financial technologies and to changes in client demand for financial services. The Government needs
to seriously consider an increase in management
autonomy in the banking industry, because it is essential to efficient management.
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Operational Efficiency
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A STUDY OF FINANCIAL MARKETS
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102
Autonomy and sound governance are likely to be
achieved after privatization of banks has taken place.
The Narasimham Committee’s observation that most
banks do not even have updated instruction manuals
proves the point. RBI’s selection of statutory auditors for banks may seem to conflict with the requirement for sound corporate governance. However, such
regulatory intervention will remain useful until banks
can fully strengthen their internal systems and procedures, risk management standards, and the required
preventive and detective controls.
Recruitment and workforce management as well
as remuneration management should be left for banks
to handle. But apart from exceptional cases, this is not
a priority area. Although the problem of overstaffing
is a legacy not easy to get rid of, it has been halted
since 1985/86 through restrictions in fresh recruitment.
All appointments of chairpersons, managing directors, and executive directors of PSBs and financial institutions should be determined by an appointment board. The Narasimham Committee felt that
there was an urgent need to raise competency levels
in PSBs through a lateral induction of talented personnel. It also indicated that the remuneration structure should be flexible and market driven.
The Government should quickly take steps to induct shareholder nominees on banks who have raised
money from the public but do not have representation on the boards.
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There are several institutes and colleges that provide skills- and management-oriented training programs to staff every year. Some are dedicated to
individual banks, while a few institutes cater to the
needs of all Indian banks and FIs. However, there
is only one institute that conducts professional ex12
aminations—the Indian Institute of Bankers, which
has completed 70 years of service to the banking
industry in the country. It develops professionally
qualified and competent bankers through examinations and continuing professional development programs.
Recognizing that the trend throughout the world is
to acquire proficiency in management through Master of Business Administration (MBA) degrees, the
institute has signed a memorandum of understanding
with the Indira Gandhi National Open University, New
Delhi, to offer an MBA in Banking and Finance. This
program will enable a practicing banker to bridge
professional experience with academic excellence.
Banks need to encourage the attainment of relevant
professional qualifications among staff, and the
institute’s activities are steps in the right direction.
Analysis of NPA management in banks has revealed that instruction manuals in most banks are
not up-to-date. Audit systems concerned with exercise of preventive and detective controls cannot be
effective in such an environment, while training systems will lack a proper foundation. RBI should assign proportionate punitive negative ratings to banks
for such deficiencies. The Narasimham Committee
(II) has also called for the updating of manuals in
banks. Another area of training should concern codes
of ethics and public accountability.
Reduction in Priority Sector Loans
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Human resources are not merely an asset but the
real capital of a bank. Banking in the future will require knowledgeable workers. A bank should have a
group of chief officers in a variety of fields so that
the collective wisdom of their organization is at the
fingertips of every employee. An integrated body of
knowledge and professionalism in banking has to be
in place to ensure continued financial viability. Staff
morale plays a crucial role in developing good organizational culture. In that context, training is going to
be an important factor.
Resuming recruitment of young trainees, training
and retraining of personnel, accelerated promotions
for young people through competition, studious habits, strong staff management, matching resources with
emerging responsibilities, developing backup support
to determine recruitment needs of new skills, and
spread of an IT culture are among the issues that
have to be addressed. The focus should be to create
core competencies for handling various types of risks
and customer sophistication, to meet all needs, from
rural to urban.
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Human Resources Development
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It will also have to reorient economic governance
to ensure that transaction costs to the public, trade,
industry, and financial sectors are reduced or eliminated. For example, in 1998, the Government released
an autonomy package for nine more PSBs (totaling
14 as of 31 March 1998), which result in the elimination of consultations and delays in decision making.
A step further would be to install regional boards for
PSBs in order to delegate power and improve operational governance. Centralization has built rigidities, fostered mediocrity, and curbed bank expansion
in the rural and semi-urban areas. If the Government’s plan to computerize all branches is to be
achieved, capital will be required that can be found
only through cost cutting which itself is dependent
on decentralization. Nationalized banks need to have
regional boards of directors like SBI to decentralize
decision making.
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THE INDIAN BANKING SECTOR: ON THE ROAD TO PROGRESS
Both Narasimham Committees recommended that
the directed credit component needs to be reduced
from 40 to 10 percent since contamination of banks’
balance sheets has come from payment defaults in
this sector. With more disintermediation and competition coupled with rising costs and falling income
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margins in metro and urban centers, more than 70
percent of the branch network of PSBs situated in
rural and semi-urban areas should look upon local
market opportunities as being a “priority” for the
banks themselves. These areas are rich in potential,
which banks can tap only if they can introduce technology and computerization at relatively low investment costs. Banks’ neglect in this area explains to
some extent the growth of the informal sector and
NBFCs. Yet the farming community in many states
today is well educated and needs modern banking
support, which neither foreign banks nor newly
opened private sector banks would offer.
According to data quoted in the R. V. Gupta Committee Report (April 1998) on agricultural credit
through commercial banks: “There has been an increase in the flow of credit to the agricultural sector
from Rs112.02 billion by all agencies in 1991/92 to
Rs286.53 billion in 1996/97, and to an estimated
Rs342.74 billion in 1997/98. This has been possible
on account of more refinance extended by NABARD
to rural financial institutions, RBI’s increased support by way of general line of credit to NABARD
for the short term, and introduction of special agricultural credit plans by commercial banks for this
sector. RBI has played a central role in motivating
commercial banks to place a special emphasis on
agriculture. In spite of these initiatives, there is a
perception that investments in agriculture have not
kept pace with demand.”
There is a need to review the best banking practices that brought prosperity to rural and semi-urban
areas. The causes of decline should be isolated and
tackled.
Most of the factors causing NPAs in the priority
sectors can be brought under control. The priority
sectors include SSI financing, which is handled prominently at bank branches in metro and urban areas
(not only in rural and semi-urban areas) and is commercial except that it is under priority credit. By the
same argument, agriculture financing in rural and
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A STUDY OF FINANCIAL MARKETS
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104
semi-urban areas is equally a commercial proposition. As such, the calculation of contamination coef13
ficient of directed credit requires review and should
not lead to policies that curtail financing to important
economic segments. Most important, a rural banking
system under control of NABARD is too weak to
shoulder the burden of rural credit.
The Government and banks interpret the term
“directed” as “targeted” in reference to the Narasimham Committee (I) recommendation for a “directed credit allocation to the priority sector.” The
shift in focus should be towards timely and adequate
credit to eligible borrowers. The “service area approach” introduced in 1987 that allocated command
areas to rural banks restricted the choice of bank
for borrowers and choice of borrowers for banks
that allocated command areas to rural banks. The
freedom to manage advocated by Narasimham
Committee (II) warrants abandonment of this “service area approach.”
Freedom also should exist for reporting performances in lending to agriculture with reference to
harvest periods instead of using a fixed date of
31 March, which is the banks’ balance sheet date,
when demand for agriculture credit is depressed.
The Gupta Committee has identified core human
resources problems such as staff of rural/semi-urban branches commuting daily from places where
their families can stay comfortably. Lack of recognition of performance at such branches by their senior
management is another problem.
The issue of merging RRBs to create a single rural-oriented banking institution deserves support since
recapitalization of more than 140 sick RRBs has still
not been decided. Also, capital infusion into cooperative banking is long overdue. This contrasts
sharply with the urgency with which nationalized
banks received a large amount of recapitalization
support from the Government. India cannot have a
strong banking system only for metro and urban services if it wants to be globally competitive.
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In the wake of computerization of banks, the management challenge concerns staff redundancies.
Branch expansion in rural and semi-urban areas
would be a logical way to deploy the excess staff.
Some 600 million people (out of a population of more
than 900 million) live in these areas. The populationbranch ratio of 12,000 on a gross basis needs to be
reworked separately for rural and semi-urban areas
(making allowance for good communication and
transportation networks that are available in metro
and urban areas) and improved significantly. Economic liberalization since 1991/92 has failed to fully
bring forth the “trickle down” benefits to the rural
and semi-urban poor and has instead resulted in high
investment in the luxury goods sector. The bias should
be corrected by boosting Government investment in
rural infrastructure and expanding banking activities.
RRBs are presently under the control of four
regulators: the sponsor bank, state governments,
NABARD, and indirectly RBI (under a system of
consolidated supervision to which the parent bank of
the RRB is subjected). A single countrywide entity
merging 196 RRBs of more than 14,000 branches
(functioning in 23 different states and 435 districts)
could end this fragmentation and develop a focused
system. This system could mobilize a large volume
of deposits through active management and low-cost
technology to achieve a reduction in transaction costs,
have its own dedicated training system, establish internal controls, regionalize supervision and audits,
create payment networks by having branches at each
district under which present rural branches of any
RRB fall, and provide timely, need-based credit at
each rural area.
More than 14 countries have benefited from “Project Microbanker,” a customized version of which
can be used by RRBs. Alternatively, software can
be developed that will be feasible and cost effective
if RRBs are amalgamated. A nationwide payment
and remittance system at rural level is necessary
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RURAL BANKING AND SMALL INDUSTRIAL CREDIT
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Rural Banking
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THE INDIAN BANKING SECTOR: ON THE ROAD TO PROGRESS
because there has been a regular migration of people
from different states as farm laborers and industrial
workers and these need remittance services.
Amalgamation will result in creation of a strong
national rural banking apparatus if commercial orientation and management upgrades are also tackled
alongside recapitalization. Such a large bank should
have branches at districts and state capitals to foster
strong links between these centers and outlying rural
areas where the majority of RRB branches operate.
Besides creating a strong nationwide payment network, it would achieve harmonization of policy and
growth strategies—especially in agriculture and agroindustry exports for which adequate services are not
available from commercial banks (centers where the
business potential is high). The amalgamation of
RRBs could take place through four to five subsidiaries; i.e., groups of RRBs in contiguous regions,
or by having a single amalgamated bank structure
with regional boards and a central board based on
the SBI structure.
The Government has introduced a Rural Infrastructure Development Fund, which is administered
by NABARD, for financing state governments. Perhaps a strong commercial rural-oriented banking vehicle can deliver better results.
Currently, RRBs are standalone institutions with
branches functioning in a highly adverse and isolated
environment. A centralized institution of RRBs by
merger could attract better managerial talent and also
take its cues from the corporate sector and multinationals, which regard the rural economics of India as
potentially a fast developing market. In fact, some
corporates and multinationals today are engaging
MBA degree holders qualified in rural development
subjects. Some rural areas are potential candidates
for development into export centers for which modern banking facilities should be made available, instead of making the customers commute to urban
centers to meet their international banking needs.
There are other justifications for merging RRBs
into a single unit. It is true that the merger of weak
105
Nonbanking Financial Companies
The NBFC reform agenda is complex because of
the large number of NBFCs, their locational spheres,
varied composition of assets and liabilities, failure rate,
and incidences of fraud that have caused a loss of
depositors’ confidence. There are also new requirements of credit rating, capital adequacy, statutory liquidity, and registration with RBI. In many areas,
there might be forced or voluntary closures of NBFCs
that are not able to comply with the norms. RBI
should identify such places and ask banks to open
branches to provide alternatives to depositors where
none exists.
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ral banking system will have to develop this. Profits
from agriculture produce are heavily dependent on
infrastructure and market information. Market information system is the key to development of infrastructure for rural markets. The system would include all information regarding prices, investments,
manufacturing, and requirements of all products. The
Government National Information Centers have a
big database in each state, but market-oriented use
and the sharing of it with banks are required.
Factoring Services
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units cannot build strength but the merger will attract
the required attention to the system in which the scope
for synergy is high. The risk of putting RRBs in the
same club as cooperative banks is that the method
of supervision fails to distinguish the ownership
pattern and differences between the two sets.
NABARD should benefit from realignment of its
supervisory load if RRBs are merged and provided a
strong central management. This rural banking apparatus can create competition, which is absent totally in the rural banking field. RRBs are already permitted to invest in shares and debentures and units
of mutual funds up to 5 percent of their incremental
deposits. All RRBs, if merged, could generate a sizable corpus of funds and also management competencies to handle such an investment portfolio, which
today each RRB has to separately develop.
The Narasimham Committee proposed that the
operation of rural financial institutions be reviewed
and strengthened in their appraisal, supervision, follow-up loan recovery strategies and development of
bank-client relationships, in view of the higher NPAs
in PSBs due to directed lending. With regard to CAR,
RRBs and cooperative banks should reach a minimum of 8 percent over five years. Also, all regulatory and supervisory functions over rural credit institutions should rest with the proposed BFRS.
Banks would have to offer financial solutions to
the agricultural sector and put to use expertise in
private equity, venture funding, and corporate finance
to tap the potential of agri-based businesses in
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India.
Banks and corporates as well as cooperatives will
have to take into account changes in consumer attitude toward processed food and modernize the distribution and retail systems. There should be proper
advisory services, project financing, venture capital,
strategic and private equity and asset financing—
including off-balance sheet financing—to come up
with investments in this sector. Though India is the
third largest producer of fruits and vegetables in the
world, it lacks a market information system. The ru-
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A STUDY OF FINANCIAL MARKETS
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106
Factoring services have not taken off even though
they improve velocity of receivables, thus affording
better credit control. Only three important factoring
systems have been established, namely, SBI, Canara
Bank, and SIDBI. Experience of existing factoring
companies in India is that average credit period of
receivables is cut by more than 25 percent resulting
in cost reduction of working capital. The rigorous
follow-up by factoring companies also decreases
debt delinquency.
Application of electronic data interchange (EDI)
needs to be progressively adopted to accelerate
growth of factoring services. Banks, corporates,
medium-size industries, and SSIs should unite to develop electronic message formats in receivable portfolio management and collection systems.
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Universal Banking
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Current account convertibility (CAC) is not going to
benefit Indian banks, which still have to get to grips
with the full-scale convertibility on current accounts
in force for the last few years. At the macroeconomic level, there are two aspects that merit special
attention: India’s external debt is now close to
$100 billion; and it has a strong parallel economy
(black market), which can weaken its balance of
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Capital Account Convertibility vs.
Banking Sector Vulnerability
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External sector development, particularly with respect
to trade, should continue to be a major concern if
stable growth is to be encouraged and economic competitiveness enhanced.
If export performance does not improve, the consequences for the banking and financial sectors might
be serious. External assistance to the export sector
should be extended by multilateral agencies through
the Indian banks and FIs. During 1989/90, the World
Bank extended loans to Indian banks to finance export projects and to allow repayments to be retained
as equity for banks. This should be undertaken again
in the current and future financing activities of multilateral loan institutions.
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External Sector
payments in a CAC type of regime. The Government should improve its utilization of aid funds and
foreign capital rather than just basing economic
growth requirements on free capital inflows (which
cannot be obtained unless outflows are freed).
Indian banks need to become competitive with
branches of foreign banks in centers where both exist,
and the number of such centers ought to be enlarged
to promote modernization in Indian banks. There is
no risk of Indian banks being dislodged from their
prime position in the home market if more branches
of foreign banks open at important centers nor can
their foreign branches become internationally competitive since capital that Indian banks can spare for
foreign branches is marginal and low.
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The adoption of EDI will allow computer-to-computer exchanges of business transactions such as
purchase orders, invoices, shipping notices and other
standard business correspondence between trading
partners. Exporters and importers as well as domestic traders can translate all foreign or domestic traderelated documents electronically without any human
intervention from their own premises, drastically reducing paperwork and increasing efficiency. Even
though measures are being taken to increase exports
and earn foreign exchange, the nonimplementation
of EDI is proving to be a major obstacle to boosting
exports because many countries carry out trade
transactions mostly electronically.
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THE INDIAN BANKING SECTOR: ON THE ROAD TO PROGRESS
Caution must be applied on universal banking because of the following considerations:
• disintermediation (i.e., replacement of traditional
bank intermediation between savers and borrowers by a capital market process) is only a decade old in India and has badly slowed down
due to loss of investor confidence;
• there is ample room for financial deepening (by
banks and DFIs) since loans market will continue to grow;
• DFIs as holders of equity in most of the projects
promoted in the past have never used the tools
advantageously;
• DFIs are now only moving into working capital
finance, an area in which they need to gain a lot
of experience and this involves creation of a network of services (including branches) in all fields:
remittances, collections, etc.; and
• reforms of India’s capital market is still at the
halfway stage. The priority will be to ensure
branch expansion, financial deepening of the
credit markets, and creation of an efficient credit
delivery mechanism that can compete with the
capital market.
107
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The Narasimham Committee recommended that
banks and primary dealers alone should be allowed
in the interbank call and notice money market.
NBFCs would get access to other forms of instruments in the money market such as bill rediscounting, commercial papers, and T-bills. It also suggested
opening the T-bill market to FIIs to broaden its base.
The imperfections of money market lie in the traditional nomenclature used; for instance, the “call
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Money Market
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A STUDY OF FINANCIAL MARKETS
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108
money market,” which, instead of allowing clearance
only of temporary surpluses and deficits, is actually
treated as a source of regular funding by banks (particularly foreign banks). The need is to remove the
word “call” from various reports and publications of
RBI and define it clearly as a composite money market for call funds and term funds. There is little activity in the term funds market even though the liability structure of banks and DFIs has undergone a considerable transformation.
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ment leasing, hire purchase finance, and factoring services
would also be covered within the above exposure ceiling.
Banks undertaking factoring services departmentally
should carefully assess the clients’ working capital needs
taking into account the invoices purchased. Factoring
services should be extended only in respect of those invoices that represent genuine trade transactions. Banks
should take particular care to ensure that by extending
factoring services, the client is not overfinanced. No worthwhile progress has taken place, reflecting apathy of banks
towards factoring.
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9RBI constituted in 1997 a working group under the chair-
manship of S. H. Khan, Chairman of Industrial Development Bank of India, to (i) review the roles, structures and
operations of development finance institutions (DFIs) and
banks in the emerging operating environment; (ii) suggest measures for bringing about harmonization in lending and working capital finance by banks and DFIs; (iii)
examine scope for increased access to short-term funds
by DFIs; and (iv) strengthen organization, human resources, and related issues of DFIs and banks in the prospect of introduction of capital account convertibility.
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of banks, RBI felt the need for a review of existing systems
for which a working group under the chairmanship of
Rashid Jilani, chairman of Punjab National Bank, was set
up in 1996. The committee made several important recommendations, which RBI accepted and directed banks to
follow.
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10To strengthen internal audit and inspection machinery
11ATM is deemed as a branch, being a service provider.
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12The main objectives of the institute are as follows:
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advances and should accordingly be given risk weight of
100 percent for calculation of capital-to-risk-asset ratio.
Further, the extant guidelines on income recognition, asset classification, and provisioning would also be applicable to them.
Abank’s exposure shall not exceed 25 percent of the banks’
capital funds to an individual borrower and 50 percent to a
group of borrowers. The facilities extended by way of equip-
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7These activities should be treated on par with loans and
the chairmanship of Dr. Sukhamoy Chakravasti to review
the workings of the monetary system. The report of this
committee provided several directions to the future shape
of financial sector reforms. Among its various recommendations, the Committee advocated stricter credit discipline
and a reduction in the importance of cash credit, greater
resort to financing of working capital through loans, bills,
and receivables.
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than recognizing that rural banking promoted since 1969
up to 1991 has transformed several poverty regions to
high levels of prosperity.
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6The mindset is loaded with concerns over poverty more
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producers.
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5Production of milk. India is among the world’s biggest
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The accumulation of and age of cases remaining undisposed are large and recovery suits filed by banks lie in the
queue. The Reserve Bank of India’s Health Code Scheme
in the 1980s impelled segregation of loan assets by quality of bank balance sheets, which until 1992 (when the
formal reform process started) showed a rosy picture. Banks
did not take full advantage of the Health Code classification with the result that bad borrowers got an extended
breather to saddle banks with loss assets.
8The Government appointed in 1985 a committee under
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4India’s judges/people ratio is the lowest in the world.
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quent upon enactment of the Recovery of Debts due to
Banks and Financial Institutions Act of 1993 (pursuant to
recommendations of Narasimham Committee ) but have
not made much impact on recovery performance of banks.
The number of DRTs has remained inadequate with disposal of cases slow, as gathered from data recorded in
para 2.95 of RBI Report on Trends and Progress of Banking in India, 1997-1998. DRTs are known to have functioned with multiple states jurisdiction and inadequate
infrastructure, a reason why the Working Committee on
DRTs was set up in 1998 by RBI/Government to look into
the related problems.
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3Debt Recovery Tribunals (DRTs) are established conse-
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2The ordinance came into effect on 31 October 1998.
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SBI were formerly Imperial Bank of India, Ltd. and Major
Princely State Banks, respectively. It is legally prescribed
that RBI must hold at least 55 percent of SBI.
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1The State Bank of India (SBI) and Associate Banks of
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Notes
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THE INDIAN BANKING SECTOR: ON THE ROAD TO PROGRESS
• to encourage the study of banking and institute a system of examinations, certificates, scholarships, and prizes;
• to promote information on banking and related subjects
through lectures, discussions, books, correspondence
with public bodies and individuals, or otherwise; and
• to collect and circulate statistics and other information
relating to the business of banking in India.
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the future market size of India’s basic food sector as
follows: dairy, $11 billion; animal feed and poultry,
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14 A McKinsey & Company/Faida Report estimated
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(II) report.
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13See p. 25, paragraph 3.31 of the Narasimham Committee
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A STUDY OF FINANCIAL MARKETS
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110
$10 billion; wheat milling and processing, $6 billion;
and beverages, $4 billion by 2005. There would emerge
the concept of “large market high growth segment” for
India and the need for the development of larger food
and agriculture companies and necessary funding arrangements.
doc_391791451.pdf